Economics 311 Money and Banking Quiz 1- Inter Temporal Budget Constraint Spring 2010

Question Consider a person who earns $100,000 today and will expects to earn $59,000 in the future.  Draw the person’s inter-temporal budget constraint if he had access to financial markets and could borrow and lend at an interest rate of 5%.  What is the present and future value of his income stream? Label this points on your graph.  Draw indifference curves consistent with the observation that the person consumes the same amount today as he will in the future, i.e. current consumption equals future consumption.  How much will he consume today and in the future? Will he be a net borrower or net saver today? How much will borrow or save?  Draw indifference curves consistent with your answers to parts (3) and (4).  If he borrowed or lent by trading bonds, would the person buy or sell bonds? Suppose the government engaged in a fiscal policy where the person expected his taxes to increase in the future, i.e. future income is expected to decrease. An example of such a fiscal policy is an increase in current government spending financed by government borrowing.  Show the effect on the person’s inter-temporal budget constraint.  Depict the effect of this fiscal policy on current consumption/demand for good and services.  Draw indifference curves consistent with your answer to (2).  Is this fiscal policy likely to end an ongoing recession? Explain

Future Consumption Current Consumption 59K 59K + 100*1.05 = $164K 100K 80K 100K + 59K/1.05=$153, Net saver who sells bonds. Lower Expected Future Income Decrease in future expected income reduces current consumption.