ECON 321

Macroeconomics II
Assignment - 1
Consumption theories

Last date of submission: 15th September 2018.

Problem 1. Suppose an individual lives for two periods and his life time utility function is linear
in consumption both in first and second periods, U  ctoday   future . The discount factor is  and
the interest rate is r . The present value of the life time wealth is W .

a) . Suppose (1  r ) .  , find optimal level plan for today and future.

b) Does the Euler equation hold in this case? Why or why not?

SPREADSHEET PROBLEM
Problem 2: Suppose we have a household with the following lifetime utility function:

U  ln Ct   ln Ct 1
1. Please compute indifference curves numerically in an excel file. Suppose that β = 0.95.
Create range of values of Ct 1 from 0.5 to 1.5, with a space of 0.01 between (i.e. create a
column of potential Ct 1 values ranging from 0.5, 0.51, 0.52, and so on). For each value
of Ct 1 , solve for the value of Ct which would yield a lifetime utility level of U  0 . Plot
this.
2. Re-do part (1), but for values of lifetime utility of U  0.5 and U  0.5 .
3. Verify that “northeast” is the direction of increasing preference and that the indifference curves
associated with different levels of utility do not cross.

Problem 3. Now suppose that the individual lives for N periods. Therefore, the life time utility
N
function is U    t 1u (ct ) and u '(c)  0, u ''(c)  0 . The income stream over the N periods is
t 1

yt , where t  1, 2,3....N. The interest rate is r .

a) If N   write down the Euler equation between t and t ' , where t ' = t.
b) If N   , and for simplicity , we assume that the discount factor   1 and interest rate
r  0 . Solve for the optimal consumption plan for the N periods, ct , where
t  1, 2,3.....N .
c) What is the marginal propensity to consume in period t  1?
 d) What is the marginal propensity to consume in period t  2?

Problem 4. Consider a period budget constraint of the form

ct  at 1  (1  r )at  xt

and a lifetime budget constraint of the form

 
1 s 1 s
 (
s 0 1  r
) ct s  (1  r ) at   (
s 0 1  r
) xt  s , where ct denotes consumption, at denotes interest

earning wealth, and xt is income in period t.

a) Use the period budget constraint to derive the lifetime budget constraint.
b) Use lifetime budget constraint to derive the period budget constraint.

Problem 5. A representative household maximizes


max    sU (ct  s )
{ct s , at s1 }s0
s 0

subject to ct  at 1  (1  rt )at  xt

with household’s period utility function is given by


U (ct  s ) = ct  s  ct2 s ;  0 is a parameter
2

where ct denotes consumption, at denotes assets, and xt is income in period t.

a) Derive the Euler equation to this problem.

b) Does expected consumption rise over time? For your answer distinguish the three cases
 (1  r) <1, >1 and =1.
Problem 6. Permanent income hypothesis

Suppose a representative consumer faces the objective function:


max    sU (ct  s ) where ct denotes consumption, at denotes interest earning
{ct s , at s1 }s0
s 0

wealth, and xt is income in period t.


and period utility function U (ct  s ) = ct  s  ct2 s ;  0 is a parameter and a budget constraint of
2
the form:

 
1 i 1 i
t  ( ) ci  (1  r )a0  t  ( ) xi
i 0 1  r i 0 1  r
Assume that (1 + r) β = 1

a) Use the Euler equation derived under problem 5 and the lifetime budget constraint in
order to show how actual consumption depends on lifetime wealth.
b) Derive the growth rate of consumption ct  ct  ct 1

c) What does consumption grow/shrink, i.e. when ct  0

Problem 7: Under two period consumption-saving framework, suppose a representative

consumer has following stream of income. In period 0, he earns Rs. 100 and in period 2, his
income is 50. He can borrow and lend at the same interest rate i = 11%. His preferences are
represented by the additivity separable utility function:

C01 C1
U (C0 , C1 )   0.9 1
1  1 

where the risk aversion is given by the parameter   2 .

1. Define marginal utility of consumption at t = 0 and t = 1, respectively.

2. Wrote down the consumer’s intertemporal budget constraint and the first order condition
that must be satisfied by the optimal consumption stream.
 3. Use the first order condition and the consumer’s intertemporal budget constraint to find
the consumption function in period 0 and period 1 that maximizes utility.
4. How much will the consumer save at t = 0? How much will his savings be worth at t = 1?
Taxation:


Problem 8: A representative agent maximizes lifetime utility {c , a }

max   sU (ct  s )
t  s t  s 1 s 0 s 0

ct1s  1
U (ct  s ) 
. The period utility function is given by
1 which has the property of

a constant relative risk aversion (CRRA). Suppose government imposes a consumption tax c
such that the period budget constraint is
(1   c )ct  at 1  (1  r )at  xt
a). Derive the Euler condition
b). is the tax distortionary?

Uncertainty

Problem 9: Suppose we have a portfolio of risky and non-risky assets and the representative
consumer lives only for two periods. The risky asset gives returns with initial investment. The
consumer faces two states: high (H) and low (L). The risky asset returns RH  1.15 with
probability p  3.5 and RL  0.8 with (1  p) per unit invested. Consumer also owns an
initial wealth of W0  100 with preferences represent by ln(C1 )  ln C2 .
1. Denote the fraction of the wealth invested the risky asset by  . Write down the
contingent consumptions in the high and low state, respectively CH and C L .
2. Write down the consumer maximization problem. Identify the indifferent curve and
compute the MRS.
3. Calculate the optimal choice of  .

Problem 10:

Suppose a consumer faces uncertainty over his income in period and he assumes following utility
function max E1{u(c1 )   u (c2 )} subject to c1  1  a2 ; c2  w2  (1  r )a2
Where income in period 2, w2 is uncertain. w2 is subject to two states with probability of 1  
with probability p and 1   with probability 1  p . Given these conditions, derive the Euler
condition under uncertainty.