1. The document outlines how to solve for optimal consumption (c) and savings (s) using an intertemporal budget constraint model with tuition payments. It provides the solution for different scenarios when income, interest rates, tuition, or inheritance amounts change.
2. When a lump-sum tax increases along with a government spending increase, consumption decreases due to lower disposable income, but government spending also decreases savings. The net effect is lower savings as the MPC is between 0 and 1. This causes the savings curve to shift left and increases the equilibrium real interest rate to clear the loanable funds market.
1. The document outlines how to solve for optimal consumption (c) and savings (s) using an intertemporal budget constraint model with tuition payments. It provides the solution for different scenarios when income, interest rates, tuition, or inheritance amounts change.
2. When a lump-sum tax increases along with a government spending increase, consumption decreases due to lower disposable income, but government spending also decreases savings. The net effect is lower savings as the MPC is between 0 and 1. This causes the savings curve to shift left and increases the equilibrium real interest rate to clear the loanable funds market.
1. The document outlines how to solve for optimal consumption (c) and savings (s) using an intertemporal budget constraint model with tuition payments. It provides the solution for different scenarios when income, interest rates, tuition, or inheritance amounts change.
2. When a lump-sum tax increases along with a government spending increase, consumption decreases due to lower disposable income, but government spending also decreases savings. The net effect is lower savings as the MPC is between 0 and 1. This causes the savings curve to shift left and increases the equilibrium real interest rate to clear the loanable funds market.
1. The document outlines how to solve for optimal consumption (c) and savings (s) using an intertemporal budget constraint model with tuition payments. It provides the solution for different scenarios when income, interest rates, tuition, or inheritance amounts change.
2. When a lump-sum tax increases along with a government spending increase, consumption decreases due to lower disposable income, but government spending also decreases savings. The net effect is lower savings as the MPC is between 0 and 1. This causes the savings curve to shift left and increases the equilibrium real interest rate to clear the loanable funds market.
1. There are more than one ways to solve this problem. It is generally the easiest to think from the perspective of the intertemporal budget constraint (other approaches use this constraint in one form or another). Without the tuition payment T but with initial wealth ω0, the intertemporal budget constraint from lecture is: Present value of lifetime spending = Present value of lifetime resources c1 + c2/(1+r) = y1 + y2/(1+r) + ω0
With the tuition payment as part of lifetime spending, it becomes
c1 + (c2 + Tuition)/(1+r) = y1 + y2/(1+r) + ω0
Saving in the first year is s = y1 - c1
The rest is simple. Just substitute the values into this equation and solve for c, where c = c1 = c2. As discussed in lecture, c1 = c2 when r = ρ = 10% in this case, there will be perfect consumption smoothing regardless of the specific functional form of the utility function.
c = $44,000. Then s = y1 - c = $50,000 - $44,000 = $6000.
(b) (i) y1 = $54,000, y2 = $50,000, r = 10%, Tuition = $12,600. c = $46,095. Then s = y1 - c = $7,905. This illustrates that a rise in current income increases saving.
(ii) y1 = $50,000, y2 = $54,000, r = 10%, Tuition = $12,600.
c = $45,905. Then s = y1 - c = $4095. This illustrates that a rise in future income
decreases saving.
(iii) ω0 = 1,050. c = $44,550. Then s = y1 - c = $50,000 - $44,550 = $5,450. The inheritance represents an increase in wealth. This causes an increase in consumption. With unchanged income, this reduces current saving (= y – c).
(iv) Tuition = $14,700.
c = $43,000. Then s = y - c = $50,000 - $43,000 = $7,000. The rise in targeted wealth needed in the future raises current saving.
(v ) r = 25%. Here r is different from ρ and we can no longer assume perfect
consumption smoothing. If we assume perfect consumption smoothing, then we would have found c = $44,400. Then s = y - c = $50,000 - $44,400 = $5,600. The rise in the real interest rate, with a given wealth target, reduces current saving. But this is incorrect. We will need to solve for the optimal consumption and saving from first principle, as follows.
1 An individual’s utility maximization problem is:
max U (c1 ,c2 ) = u(c1 ) + δ u(c2 )
c1 ,c2
u(c) = c = c1/2
subject to c2 y Tuition c1 + = y1 + 2 − =ω 1+ r 1+ r 1+ r ω = lifetime wealth after tuition payment
Substituting c2(c1)=(1+r)(ω - c1) and the instantaneous utility function into the maximization problem, we get an unconstraint maximization problem with only one variable
max c1 + δ (1+ r)(ω − c1 )
c1
The first order condition is:
1 −δ (1+ r) + =0 2 c1* 2 (1+ r)(ω − c1* )
Solving, we get ω 79,920 c1* = = = 39,310.24 δ (1+ r) +1 (1/ 1.1) 2 (1.25) +1 2
