ECON224 Macroeconomics II
Problem Set 2
Question 1: Chapter 9
A consumer’s current income (y) is 200 and the future income (y ′ ) is 240. A current lump-
sum tax (t) of 10 is paid and the tax in the next period (t′ ) is 15. The real interest rate is 20%
for each period. Please assume that current and future consumption are complements, and the
consumer always prefers to have one unit of current consumption and two units of consumption
in the future.
(a) Calculate the consumer’s lifetime wealth.
(b) Calculate the optimal current and future consumption and the optimal current and future
savings. Is the consumer a lender or a borrower? How does he/she, as a lender or a borrower,
affect the future consumption?
(c) Draw a diagram to illustrate the consumer’s budget constraint, indifference curve, en-
dowment point, and the optimal consumption bundle in your answer to part(b).
(d) Assume that the current and future incomes increase by 10% each, respectively. How will
such a change affect the budget constraint, the indifference curve, and the optimal consumption
bundle? Modify the diagram drawn in response to part (c) to demonstrate your answer (no
calculation is required).
(e) Calculate the new optimal current and future consumptions. Are your results consistent
with your answer to part (d)?
Question 2: Chapter 9
Assume an economy with 1, 000 consumers. Each consumer has income in the current period
of 50 units and future income of 60 units and pays a lump-sum tax of 10 units in the current
period and 20 units in the future period. The market real interest rate is 8%. Of the 1, 000
consumers, 500 consumer 60 units in the future, while 500 consumer 20 units in the future.
(a) Determine each consumer’s current consumption and current saving.
(b) Determine aggregate private saving, aggregate consumption in each period, government
spending in the current and future periods, the current-period government deficit, and the
quantity of debt issued by the government in the current period.
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(c) Suppose that current taxes increase to 15 units for each consumer. Repeat parts (a) and
(b) and explain your results.
Question 3: Chapter 9
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In a two-period model economy, there are a total N number of consumers, of which 2N
are of type A and 21 N are of type B consumers. Consumers derive utility from current period
consumption c and future period consumption c′ . For all consumers, current and future con-
sumptions are perfect substitutes. Type A consumers have M RSc,c′ = a, and type B consumers
have M RSc,c′ = b, where a < b. Each consumer receives exactly the same amount of exogenous
current and future incomes y and y ′ , and pays the same amount of lump-sum current and future
taxes t and t′ . Government expenditures are G for current period and G′ for future period. For
simplicity, there are no firms in this economy.
We assume the parameters satisfy the following conditions: N y − G > 0, N y ′ − G′ > 0 and
N y ′ −G′
a< N y−G < b.
Solve for the competitive equilibrium – the equilibrium real interest rate, and the current and
future consumption allocations for each individual consumer. Does the Ricardian Equivalence
Theorem hold in the equilibrium? Explain why or why not.
