1. Use the Life Cycle Model to answer the following. Also suppose that:

There are only 2 periods (0 and 1)

I0 = 200

I1 = 100

r = 0.2 (i.e. 20%)

a) Draw the intertemporal budget constraint. Be sure to label the axes, endowment point and the absolute value of the slope.

b) Suppose that the individual’s interest income is taxed at 25% in both periods, and that interest payments are deductible at 25%. Graph the new intertemporal budget constraint on your graph from part a.

c) What is the absolute value of the slope (or |slope| in mathematical notation) of the after-tax budget constraint?

d) On a new graph, graphically show how this tax can decrease savings.

e) On yet another graph, graphically show how this tax can increase savings.

f) What is the key difference between the two cases described in parts d and e? How is it possible for one tax to have such varied potential outcomes?

g) Suppose instead that the individual’s interest income is only taxed at 10% in period 1 (the later period, because the tax system has changed) so that any interest on saved income is now taxed at this lower rate. Redraw the graph and label the absolute value of the slope in each region. How might this affect his saving behavior?