1.

In the two-period model of optimal consumption, a rise in the interest rate will decrease
present value of life-time consumption, hence both current and future consumption will
decrease for a saver. Is this statement correct? Explain.

2. In the two-period model of optimal consumption, a rise in the real rate of interest must
reduce current consumption for borrowers. Explain.

3. In the two-period model of optimal consumption, assume that there are two types of
households - poor and rich. But for both types, Y1 = Y2 and C1 = C2 and r = 0. Now for the
poor household the first period income increases to 3Y1, with no change in Y2 and for the
rich household the first period income increases to 4Y1, with no change in Y2. Find out the
optimal C1/Y1 ratio for both households.

4. In the two-period model of optimal consumption, assume that there are two types of
households - poor and rich. But for both types, Y1 = Y2 and C1 = C2 and r = 0. Now, for the
poor household the second period income increases to 2Y2, with no change in Y1 and for the
rich household the first period income increases to 2Y1, with no change in Y2. Find the
optimal saving-to-income (S/Y1) ratio for both the households.

5. Consider the Euler equation C2/C1 = (1 + interest rate)/(1 + impatience factor). Let interest
rate = impatience factor. With this condition, write down the value/expression for MPC
(delta_C1/delta_Y1) for a permanent change in income (income increases by the same
amount in both periods).

6. Write down the expression for real interest rate as determined in a general equilibrium
condition of the entire economy (recall: S = 0 in general equilibrium). What will happen to
the interest rate if there is a temporary fall in the current level of GDP?

7. Assume that there are two types of households (one each) in the two-period model – Rich
and Poor, with the following structure.

Poor Rich

Consumption C1P , C2P C1R , C2R

Income (100, 100) (200, 200)

Utility function ln C1P + ln C2P ln C1R + ln C2R

Interest rate Zero in both cases

(i) Write down optimal values of consumption.

C1P , C2P = C1R , C2R =

(ii) Suppose that the utility function for poor changes to ln C1P + 0.5ln C2P . Write down optimal
values of consumption.

C1P , C2P =

(iii) Consider the original specification of utility functions as given in the table above. The
government wants to carry out a pure redistribution of income between two groups so that there
is no income inequality between the rich and poor in the first period. So, the government must
levy a tax on a group and just transfer that to the other group. (Note that this a balanced budget
exercise for the government).
(a) What will be the optimal consumption after redistribution?

C1P , C2P = C1R , C2R =

(b) What will be the values of the following ratios in period 1 after redistribution?

P R Total
 S1   S1   S1 
  =   =   =
 Y1   Y1   Y1 

8. In the two‐period model of optimal consumption, assume that the utility function has the
form U (C1, C2) = ln C1 + β ln C2. Assume that the values of β and interest rate are such that
β(1 + r) = 1. The income bundle is given by (Y1, Y2). Compute the value of ∆C1/∆Y1 for a
permanent change in income given by ∆Y1 = ∆Y2.

MCQs

1. Which of the following statements is incorrect in the context of long-run consumption

function?

a) Current consumption is a function of income

b) Consumption-to-income ratio is stable over time
c) Saving-to-income ratio is stable over time
d) Households with higher income save a larger fraction of their income
2. Which of the following statements is incorrect in the context of measuring MPC?

a) Measuring MPC as per Keynesian definition involves temporary changes in current

income
b) Measuring MPC as per Keynesian definition involves permanent changes in income
c) Measuring MPC as per Keynesian definition involves keeping future income constant
d) If we regress current consumption on current income, we will get MPC as per Keynesian
definition

3. Which of the following statements is incorrect in the context of Keynesian consumption

function with usual assumptions?

a) APC > MPC

b) APS can be positive or negative
c) APS is always positive
d) APC is always positive

4. Given an income stream, a person will save in the two-period model when

a) she equally likes current and future consumption

b) she likes current consumption more than future consumption
c) she likes future consumption more than current consumption
d) More information is required to answer this question

5. In the two-period model, consider Y1 = Y2, and C1 = C2 for some consumer. Then at the
same interest rate,

a) this consumer is not saving anything now, and can never be a saver
b) this consumer is not saving anything now, but can save if Y1 increases
c) this consumer is not borrowing anything now, and will never be a borrower
d) this consumer is not saving anything now, but can save if Y2 increases

6. Life-cycle hypothesis postulates that,

a) Across households, income varies proportionately with wealth, so high-income

households should have a lower APC than low-income households
b) Across households, income varies more than wealth, so high-income households should
have a higher APC than low-income households
c) Across households, income varies proportionately with wealth, so high-income
households should have a higher APC than low-income households
d) Across households, income varies more than wealth, so high-income households should
have a lower APC than low-income households
7. If a person faces absolute borrowing constraint, then an increase in future income will,

a) make this this person better off as consumption increase in both periods due to
consumption smoothing
b) make this person worse off as current consumption does not increase
c) increase only future consumption but the effect on welfare is ambiguous
d) increase only future consumption and the effect on welfare is unambiguous

8. Permanent income hypothesis postulates that,

a) the saving-to-income ratio is affected more when there is a permanent change in income
b) the saving-to-income ratio is affected less when there is a temporary change in income
c) there will be no change in the saving-to-income ratio when there is a temporary change in
income
d) the saving-to-income ratio is affected less when there is a permanent change in income

9. Consider Y1 = Y2, and C1 = C2 for some consumer. Then the saving-to-income ratio,

a) will increase if there is a temporary increase in current income

b) will decrease if there is a temporary increase in current income
c) will increase if there is a permanent increase in the income stream
d) will decrease if there is a permanent increase in the income stream