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Question 1
C1 is present consumption
C2 is future consumption
Y1 is the present endowment
Y2 is the future endowment
r is the real interest rate between the present and the future
Ω is wealth
Which of the following equations is not the household's intertemporal budget constraint?
Your answer:
d) C1 + C2/(1+r) =
Y1 +Y2/(1+r)
Correct answer:
c) Y1 +Y2/(1+r) = Ω
Feedback:
Three equivalent ways to express the intertemporal budget constraint of a household living two
present value of lifetime saving is zero; the present value of lifetime consumption is equal to we
present value of lifetime income is equal to the present value of lifetime consumption.
Page reference: 160
Question 2
Point A represents the endowments of Crusoe for today and tomorrow and the real interest rate
wealth is equal to...
Your answer:
d) The area of the rectangle OY1AY2.
Correct answer:
a) OB
Feedback:
Key: The distance from Y1 to B is equal to the present discounted value of Y2, add that to OY1 t
wealth. See Figure 7.1
Page reference: 160
Question 3
In a two-period world where firms can invest K in the present period in order to produce F(K) in
if the real rate of interest is r, then the net return from investing K would be equal to:
Your answer:
d) K times (1+r)
Correct answer:
a) F(K)/(1+r) minus K
Feedback:
We need to compare present values with each other. Hence the gross return tomorrow needs t
we obtain the net return by deducting the current value of investment (no need to discount it).
Page reference: 163
Question 4
The reason that it does not matter whether a firm uses debt (borrowing) or equity (own saved fu
investment plans is...
Your answer:
d) ...that firms belong to their shareholders and the net return from investment raises their weal
Feedback:
The trick is to say that this is just another way of saying the household and firm budget constra
consolidated into that of the aggregate private sector. Note that Ricardian equivalence involves
of private and public budget constraints.
Page reference: 165-166
Question 5
Consider the current government budget, where:
T1 is today's net taxes.
D1 is government debt at the start of today.
G1 is today's government spending.
rG is the real interest rate paid on government debt.
All variables are positive.
The government is running a deficit today, if
Your answer:
d) (G1+ D1) rG - T1> 0
Correct answer:
c) rGD1 > T1 - G1
Feedback:
rGD1 > T1 - G1 is correct. This can be seen by moving government spending over to the left han
that total government spending, including interest payments, exceeds tax revenues. The differe
the primary deficit.
Page reference: 167
Question 6
Suppose the market interest rate is equal to 5%. The price of a bond that promises one payme
year would be equal to:
Your answer:
d) € 100 ÷ 1.05
Feedback:
Multiplying the price of the bond by 1 plus the interest rate must equal € 100. Reread Box 7.2. T
a pure discount bond.
Page reference: 161
Question 7
The difference between a nation's current account surplus and its primary account surplus is its
Your answer:
d) …net sovereign borrowing
Correct answer:
b) … net investment income from abroad.
Feedback:
See the decomposition of the current account surplus of a nation (7.14). Note that two of the in
refer to stocks whereas the current accounts surpluses asked about are flows!
Page reference: 173
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If, for Crusoe's current intertemporal consumption pattern (satisfying his intertemporal budget
constraint), his marginal rate of intertemporal substitution is 1 and the real rate of interest is positive,
then…
Your answer:
d) …Crusoe is necessarily a borrower.
Correct answer:
c) …Crusoe could increase his lifetime utility by consuming less today.
Feedback:
The interest rate is given for Crusoe, if he changes his consumption his MRS will change, not the
interest rate. We can't say whether Crusoe is a borrower or a lender for a particular consumption
pattern without first knowing what his endowment is! Since the slope of the intertemporal budget
constraint is cutting Crusoe's indifference curve at current consumption from below, he can increase
his lifetime welfare by cutting back on some consumption today, i.e. saving.
Page reference: 182
Question 2
What is the permanent income that corresponds to present value of the two period income path
Y1=100, Y2=125 for the real interest rate r=.5? Note: 50% not ½%!
Your answer:
d) 116
Correct answer:
a) 110
Feedback:
Eq. (8.2) Solve the PV equation for two periods of the unknown permanent income so that it equals
the PV of the actual income path. Or calculate PV for each possibility given.
Page reference: 185
Question 3
Crusoe begins with an endowment A. Point R is the consumption combination he would choose at
real interest rate r and point R´ is the consumption combination he would choose at real interest rate
r´.
Which of the following statements is true?
Your answer:
d) The change in interest rate does not decrease Crusoe's utility since he is free to keep his original
endowment A if he so chooses.
Correct answer:
b) Crusoe's wealth has decreased because of the change in the real interest rate.
Feedback:
See Figure 8.1. Because Crusoe's endowment and preferences are such that he is a borrower, the
increase in the interest rate hurts him. Note the MRS = 1+r.
Page reference: 188
Question 4
There are strong theoretical reasons to expect that changes in wealth are responsible for changes in
consumption, nonetheless one reason that we observe a tight link between consumption and
disposable income is…
Your answer:
d) …Ricardian equivalence.
Correct answer:
a) …credit rationing changes the intertemporal budget constraint for borrowers.
Feedback:
The assumption that households can borrow as much as they would like at the common market
interest rate is an oversimplification which covers up the general inability young people have to
borrow against future potential income. They are credit rationed.
Page reference: 189
Question 5
The accelerator principle states:
Your answer:
d) Small swings in investment are associated with large swings of output.
Correct answer:
a) If an increase in the growth of output is expected, investment will increase.
Feedback:
One of the explanations for the relative volatility of investment spending. Do not confuse the
investment accelerator with the investment multiplier.
Page reference: 195
Question 6
Which of the following factors does Tobin's q ratio not reflect:
Your answer:
d) …the interest rate.
Correct answer:
a) …marginal rate of intertemporal substitution
Feedback:
The marginal rate of intertemporal substitution is a factor for understanding intertemporal choices
regarding consumption.
Page reference: 196
Question 7
The optimal capital stock is achieved when the user cost of capital is equal to
Your answer:
d) …Tobin's q
Correct answer:
c) …the marginal product of capital
Feedback:
See Box 8.6. User cost of capital is the sum of the interest rate and the depreciation rate. If you
spend € 1 on new capital, it will produce the MPK. Your capital after the period of production is only
worth 1-d (where d is the rate of depreciation) and the opportunity cost of buying the capital for that
period was the real interest rate r plus the principal returned to you of 1. When MPK + (1-d) = (1+r),
then you have the right amount of capital, i.e. MPK = d + r.