Economics 311

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

2. 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

3. Future Consumption 59K + 100*1.05 = $164K Net saver who sells bonds. 80K Decrease in future expected income reduces current consumption. 59K Lower Expected Future Income 100K + 59K/1.05=$153,333.33 80K 100K Current Consumption