Lahore School of Economics

MPHIL Advanced Macroeconomics I

Spring 2011

Problem Set 2

1. Consider the optimal consumption path of a person who will live exactly T
periods. In the first period, she has labor earnings of one unit. Subsequently,
her wage grows at rate g, so that in the second period she earns 1+g, in the
third period (1+g)2, etc. She can borrow or lend at an interest rate of zero,
and she discounts future utility at rate zero. Her instantaneous utility
function is of the CRRA form. She starts and ends life with zero assets.

Calculate saving in the first period of life (that is, first period income minus
first period
consumption). What is the effect of increasing g on first period saving?
Explain.

2. Mr. A and Mr. B have the same preferences (that is, the same
instantaneous utility function and the same discount rate). Both are born at
time zero and die (with certainty) at time T. Both face the same interest rate.
Each is born with zero assets and dies with zero assets. Both are also
liquidity constrained: they are never allowed to have negative assets. They
have different lifetime wage profiles. There is no uncertainty: both
individuals know in advance their entire lifetime wage profiles.

It is observed that Mr. A's consumption grows at a constant (positive) rate

over the course of his life, while Mr. B's consumption declines at a constant
rate over the course of his life. The rate at which Mr. B's consumption
declines is smaller than the rate at which Mr. A's consumption grows.
However, the present discounted values of lifetime consumption for the two
men are the same.

Which man has higher lifetime utility? Explain.

3. An individual lives for two periods. In each period she earns labor income
of 1. Her utility function is:

U = ln(c1) + ln(c2)
She can borrow or lend some financial asset that pays a real interest rate of
zero. However, there is a 50% chance that between periods 1 and 2 all debts
and financial wealth we be wiped out (there is no other way that she can
save between periods other than the financial asset). That is, if she borrows,
there is a 50% chance that she will not have to pay back the loan, and if she
saves, there is 50% chance that all her saving will disappear. Solve for her
optimal first period consumption.

4. A person lives for two periods. In the first period she has income of 8
dollars. In the second period, she has income of either 0 or 8 dollars, each
with probability .5. The interest rate is zero.

Her instantaneous utility function is:

U(c) = c - .05*c2

Her discount rate is zero.

There is a test that can tell the person what her second period income will be
before she
makes her first period consumption decision. If she does not take the test,
then she will not know her second period income until after the first period is
over. The test costs 2 dollars. Calculate whether she should take the test or
not.