EBIE222207: Makroekonomika 2

Problem Set 3
Suggested Solutions

1. (10 points) In the two-period credit market model, what does a consumer do in response when the
real interest rate increases? How does your answer depend on whether the consumer is a borrower/lender
initially? Explain.
Solution:

The increase in the real interest rate increases the slope of the consumer’s lifetime budget constraint, and
causes the constraint to pivot around the endowment point. The consumer experiences a positive income
effect, causing consumption to go up in both periods. But there is a substitution effect–consumption is
now more expensive in the current period relative to the future period. So, the substitution effect is for
consumption to fall in the current period and increase in the future period. Therefore, consumption must
increase in the future, but consumption in the present may increase or decrease, and savings may increase
or decrease.
2. (20 points) Suppose that all consumers are identical, and also assume that the real interest rate r is fixed.
Suppose that the government wants to collect a given amount of tax revenue R, in present-value terms.
Assume that the government has two options: (i) a proportional tax of s per unit of savings, in that the tax
collected per consumer is s(y −c); (ii) a proportional tax u on consumption in the current and future periods,
uc0
so that the present value of the total tax collected per consumer is uc + 1+r . Note that the tax rate s could
be positive or negative. For example if consumers borrow, then s would need to be less than zero for the
government to collect tax revenue. Show that option (ii) is preferable to option (i) if the government wishes
to make consumers as well of as possible, and explain why this is so. [Hint: Show that the consumption
bundle that consumers choose under option (i) could have been chosen under option (ii), but was not.]

Solution:
Let (c1 , c01 ) denote the consumption bundle chosen by each consumer under the first tax scheme with tax
rate s on savings, and (c2 , c02 ) the consumption bundle chosen if the consumer faces the tax scheme with tax
rate u on current-period and future-period consumption. Then, since the consumer’s budget constraint is
satisfied in each case, then:
c0 y0
c1 + 1 = y + − s(y − c1 ) (1)
1+r 1+r
and
(1 + u)c02 y0
(1 + u)c2 + =y+ . (2)
1+r 1+r
As well, since tax revenue generated in each case is R, we have:

c0i y0
ci + =y+ −R (3)
1+r 1+r

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for i = 1, 2. Then, equations (2) and (3) give
R
u= y0
. (4)
y+ 1+r −R
Thus,
0
y
c0 (1 + u)  c0  y + 1+r 
c1 (1 + u) + 1 = c1 + 1 y0
1+r 1 + r y + 1+r −R
y0
=y+
1+r
In the preceding equation, the first equality follows from equation (4), and the second from (3). Therefore,
the consumption bundle (c1 , c01 ) is affordable under the second tax system. But that was not the consumption
bundle the consumer chose. The consumer chose the consumption bundle (c2 , c02 ), which is not the same as
(c1 , c01 ), as the consumer’s marginal rate of substitution will be different under the two tax systems. As a
result, consumers are better off under the second tax system than the first, as the second tax system does not
distort the choice the consumer makes over current consumption vs. future consumption–under the second
system current and future consumption are taxed at the same rate.
3. (20 points) Suppose that the government introduces a tax on interest earnings. That is, borrowers face a
real interest rate of r before and after the tax is introduced, but lenders receive an interest rate of (1 − x)r
on their savings, where x is the tax rate. Therefore, we are looking at the effects of having x increase from
zero to some value greater than zero, with r assumed to remain constant.
a. Show the effects of the increase in the tax rate on a consumer’s lifetime budget constraint.
Solution: Initially, AB in the left figure in the following set depicts the consumers budget constraint.
The introduction of the tax results in a kink in the budget constraint, since the interest rate at which
the consumer can lend,(1 − x)r is now smaller than the interest rate at which the consumer borrows,
r. The kink occurs at the endowment, E.

b. How does the increase in the tax rate affect the optimal choice of consumption (in the current and
future periods) and saving for the consumer? Show how income and substitution effects matter for
your answer, and show how it matters whether the consumer is initially a borrower or a lender.

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 Solution: The first figure shows the case of a consumer who was a borrower before the imposition of
the tax. This consumer is unaffected by the introduction of the tax. The second figure in the preceding
shows the case of a consumer who was a lender before the imposition of the tax. Initially the consumer
chooses point G, and then chooses point H after the imposition of the tax. There is a substitution effect
that results in an increase in first-period consumption and a reduction in second-period consumption,
and moves the consumer from point G to point J. Savings also fall from point G to point J. The
income effect is the movement from point J to point H, and the income effect reduces both first-period
and second-period consumption, and increases savings. On net, consumption must fall in period 2,
but in period 1, consumption may rise or fall. The figures above show the case in which first-period
consumption falls, which is a case where the income effect dominates.

4. (10 points) In the credit market model with asymmetric information, determine how a consumer will
respond to an increase in the fraction of bad borrowers in the population. And discuss how the credit
market model with asymmetric information shows how a financial crisis can reduce consumption.

Solution:
An increase in the fraction of bad borrowers in the population acts to increase the loan rate faced by all
borrowers, and increase the interest rate spread between borrowing and lending rates. This shifts the budget
constraint in for good borrowers, who will therefore borrow less and consume less in the present. This has
no effect on lenders, as the interest rate they face will not change, and banks continue to earn zero profits.

In the credit market model with asymmetric information, the interest rate at which all borrowers borrow
reflects a default premium. This is because banks, which are doing the lending, have difficulty telling apart
good borrowers who never default from bad borrowers who always default. When there are more bad
borrowers in the population, as is the case in a financial crisis, the default premium rises, and there is a
larger spread between lending and borrowing rates of interest. For borrowers–even good ones–the interest
rates they face rise, as the credit market has become contaminated with potential default. So, facing higher
interest rates, even creditworthy borrowers cut back on their borrowing, and reduce consumption.
5. (20 points) Suppose there are two groups of consumers in a population, constrained and unconstrained,
with equal number of each. The constrained consumers look like the ones in Figure 10.5, while the uncon-
strained consumers do not have sufficient collaterizable wealth to support the amount of borrowing they
would like to do. The government decides that it will tax each constrained consumer by an equal amount in
the current period and distribute the tax revenue equally among the unconstrained consumers as transfers.
a. (10 points) Take the market real interest rate as given and determine the effect of the redistribution
by the government on the total demand for consumption goods in the current period and in the future
period. (Only determine the net effects on the demand for consumption goods, given the real interest
rate.)
Solution: The constrained consumer’s current consumption is:
pH
c=y−t+ .
1+r
The constrained consumer’s future consumption is:
pH
c0 = y 0 − t0 + .
1+r
In this case, the constrained consumer’s lifetime wealth is:

c0 y0 t0
we = c + =y+ −t− .
1+r 1+r 1+r

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 The unconstrained consumer’s current consumption is:

c + s = y + t.

The unconstrained consumer’s future consumption is:

c0 = y 0 + t0 + s(1 + r).

In this case, the unconstrained consumer’s lifetime wealth is:

c0 y0 t0
we = c + =y+ +t+ .
1+r 1+r 1+r

b. (5 points) What do your results tell you about a fiscal policy aimed at redistributing income toward
those who will tend to spend more of it?
Solution: The fiscal policy, in this case, is very restrictive as it does not help constrained consumers
who are already affected by collateralized wealth. Thus, the tax fiscal policy does not increase the
general economic welfare.

c. (5 points) Determine an efficient tax policy. This will be the tax policy that relaxes the limited
commitment constraint for consumers.
Solution: An efficient tax policy would be a tax cut for the constrained consumer at the same rate of
interest. The constrained consumer goes back to the initial consumption bundle with the amount of
the tax cut −∆t.

Note that the constrained consumers have already collateralized their wealth, and a tax will reduce
their lifetime wealth even more, thus reducing their overall lifetime wealth. The budget constraint
moves further left. The total demand for the constraint consumers will fall. This means that the
current period consumption can be no greater than the current disposable income plus the amount
that resulted after the collateralized wealth plus the tax. In the case of unconstrained consumers, there
are no subjects of collateralized wealth and they are also given the redistribution in the future period.
Their lifetime wealth increases and the demand for consumption goods also increases. This means that
the future period consumption is greater than the disposable income with the redistribution of the tax,
meaning saving for the unconstrained consumer.

6. (20 points) Consider a pay-as-you-go social security system where social security is funded by a pro-
portional tax on the age of the young (less before the age of 40, more after 40). In other words, the tax
collected by the government is sc, where s is the tax rate and c is the consumption of the young. Retirement
benefits are provided as a fixed amount b to each old consumer. Can social security improve lifetime wealth
for everyone in this situation? Use diagrams in your answer.
Solution:
Under this regime, the disposable income for the young is y, but the price for current consumption is (1 + s).
Thus, in equilibrium, the intertemporal budget constraint is:

sc(1 + n) = b.

Over time, when talking about the young, regardless of age, the tax will be the same when taken in general.
This implies that the intertemporal budget constraint is:

y + y 0 + b = c(1 + s) + c0 .

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If n > r, then social security increases the welfare of old people. However, there is also a substitution effect
coming from the change in relative price between c and c0 . This substitution comes in no welfare to the
young.