METU Department of Economics

2024 – 2025 Spring

Econ 204, Section 2

Problem Set III

Question 1

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Question 2
Suppose that there is a household who lives for two periods. Its lifetime utility function is:

U = u(Ct) + βu(Ct+1)

u( ) is a function that is increasing and concave (the first derivative is positive and the second
derivative is negative). The household faces two within period budget constraints:

𝐶! + 𝑆! = 𝑌!

𝐶!"# = 𝑌!"# + (1 + 𝑟! )𝑆!

𝑟 ! is the interest rate on the stock of savings brought from period t into period t + 1. The
household would like to pick consumption and saving to maximize lifetime utility subject to the
two budget constraints.

a) Solve for 𝑆! from either the t or t + 1 budget constraints, plug it into the other, and derive the
unified, intertemporal budget constraint. In words, describe what the intertemporal budget
constraint says.

b) Solve for 𝐶!"# in terms of 𝐶! , 𝑌! , 𝑌!"# , and 𝑟 ! in the intertemporal budget constraint you
derived on part (a). Plug this into the objective function, which turns the problem into an
unconstrained maximization problem just over 𝐶! . Derive the Euler equation (first order
necessary condition for a maximum). Provide an economic interpretation of the Euler equation.

c) Define an indifference curve and derive an expression for the slope of the indifference curve.

d) Combine the indifference curve with a graphical representation of the intertemporal budget
constraint (what we call in the graph the “budget line”). Graphically show the optimal
consumption bundle.

e) Suppose that there is an increase in 𝑌! . Graphically show how this ought to affect 𝐶! and 𝐶!"# .

f) Suppose that there is an increase in 𝑌!"# . Graphically show how this ought to affect 𝐶! and
𝐶!"# .

g) How does first period saving, 𝑆! , react differently to an increase in 𝑌! relative to an increase in
𝑌!"# ?

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Question 3
A consumer’s income in the current period is y = 100, and income in the future period is
y’ = 120. He or she pays lump-sum taxes t = 20 in the current period and t’ = 10 in the future
period. The real interest rate is 0.1, or 10%, per period.

a) Determine the consumer’s lifetime wealth.

b) Suppose that current and future consumptions are perfect complements for the
consumer and that he or she always wants to have equal consumption in the current and
future periods. Draw the consumer’s indifference curves.

c) Determine what the consumer’s optimal current-period and future-period

consumptions are, and what optimal saving is, and show this in a diagram with the
consumer’s budget constraint and indifference curves. Is the consumer a lender or a
borrower?

d) Now suppose that instead of y = 100, the consumer has y = 140. Again, determine
optimal consumption in the current and future periods and optimal saving, and show this
in a diagram. Is the consumer a lender or a borrower?

e) Explain the differences in your results between parts (c) and (d).

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Question 4
Consider a two-period economy (with no government), in which the representative consumer has
no control over his income. The lifetime utility function of the representative consumer is

𝑢(𝑐# , 𝑐$ ) = 𝑙𝑛𝑐# + 𝑙𝑛𝑐$

where 𝑙𝑛 stands for the natural logarithm. We will work here in purely real terms: suppose the
consumer’s present discounted value of ALL lifetime REAL income is 26. Suppose that the real
interest rate between period 1 and period 2 is zero (i.e., r = 0), and also suppose the consumer
begins period 1 with zero net assets.

a) Set up the lifetime Lagrangian formulation of the consumer’s problem, in order to

answer the following:

i) is it possible to numerically compute the consumer’s optimal choice of

consumption in period 1? If so, compute it; if not, explain why not.

ii) is it possible to numerically compute the consumer’s optimal choice of

consumption in period 2? If so, compute it; if not, explain why not.

iii) is it possible to numerically compute the consumer’s real asset position at

the end of period 1? If so, compute it; if not, explain why not.

b) To demonstrate how important the concept of the real interest rate is in

macroeconomics, an interpretation of it is that it reflects the rate of consumption growth
between two consecutive periods. Using the consumption-savings optimality condition
for the given utility function, briefly describe/discuss whether the real interest rate is
positively related to, negatively related to, or not at all related to the rate of consumption
growth between period one and period two. For your reference, the definition of the rate
%
of consumption growth rate between period 1 and period 2 is %! − 1.
"

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Question 5
Suppose that the government introduces a tax on interest earnings. That is, borrowers face a real
interest rate of r before and after the tax is introduced, but lenders receive an interest rate of
(1 - x)r on their savings, where x is the tax rate. Therefore, we are looking at the effects of having
x increase from zero to some value greater than zero, with r assumed to remain constant.

a) Show the effects of the increase in the tax rate on a consumer’s lifetime budget
constraint.

b) How does the increase in the tax rate affect the optimal choice of consumption (in the
current and future periods) and saving for the consumer? Show how income and
substitution effects matter for your answer, and show how it matters whether the
consumer is initially a borrower or a lender.

Question 6
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 consume 60 units in the future, while 500 consume 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.

c) Suppose that current taxes increase to 15 units for each consumer. Repeat parts (a) and
(b) and explain your results.