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

80K

100K + 59K/1.05=$153,333.33

Net saver who sells bonds.

Lower ExpectedFutureIncome

Decrease in future expected income reduces current consumption.