1. Explain what the NL/NB point on a consumption model represents. What happens to this point when the real interest rate changes? Why does this happen?
2. Suppose we have Dagwood, who has a current income of y and expected future income of yf. He has a in current wealth and he has zero expected future wealth, af.
Dagwood's behavior is consistent with the life-cycle theory of consumption. For one, he perfectly smooths consumption and two, since he is in his peak earning years; he is saving now so that he can maintain his current level of consumption in the future.
Initially, Dagwood faces a 0.05 real interest rate.
Now Dagwood gets a letter in the mail about his 401k: "ouch" he says, his current wealth, a, has lost eighty percent (80%) of its value.
Is Dagwood worse off or better off? Explain by discussing the consumption model and what happens to his budget constraint. Be sure to discuss in detail.
3. Suppose you are Janet Yellen's cousin and was head of the central bank in an economy filled with savers. Suppose also that your economy was in a recession and you wanted to stimulate consumption today as part of your dual mandate. Suppose the current real rate of interest is zero. Would you raise or lower real interest rates to stimulate consumption? Explain in detail using the substitution and income effects.
4. How does a change in the real interest rate affect savers differently than it affects borrowers? Use and define the income effect and the substitution effect in your answer.
5. Explain how an increase in the real interest rate (r) would influence the uc/MPKf diagram and how it would influence the desired investment (Id) diagram.