SEM 1

Question 1

Key features of Keynes consumption and problems

Answer 1

Disposable income is main component
MPC=0-1
APC= the ratio of consumption to Y decreases as Y increases
Problems: keynes predicted C would grow more lowly than Y over time this did not come as APC did not fall

Question 2

Irving and fisher intertemporal choice assumptions

Answer 2

consumers are forward looking and chooses consumption for the present and future to maximise lifetime satisfaction
Intertemporal budget constraint measure of total resources available to consumer overtime

Question 3

derive Intertemporal budget constraint

Answer 3

L1

Question 4

Draw an intemporal budget constraint

Answer 4

L2

Question 5

What does 1+R represent intertemporal budget constraint

Answer 5

the relative price of consumption in terms of future consumption

Question 6

What is an endowment point

Answer 6

it determines exogenous income at time t and time t+1

Question 7

Draw an optimal choice on an intertemporal budget constraint

Answer 7

L2

Question 8

Where is the optimal point on an intertemporal budget constraint

Answer 8

where the slope of the budget constraint= slope of indifference curve i.e. (1+r)=MRS ct,ct+1

Question 9

What is the MRS of ct and ct+1

Answer 9

a rate at which a consumer is willing to give up future consumption to get a unit of current consumption is equal to the rate prevailing in the market.

Question 10

Show a borrower on a intertemporal budget constraint

Answer 10

L2

Question 11

Show the impact of a lender when interest rates increase intertemporal budget constraint diagram showing sub and income effect

Answer 11

L2

Question 12

Substitution effect with relation to intertemporal budget constraint

Answer 12

Sub- change in consumption purely due to change in relative price of future consumption

Question 13

Derive the Euler equation form current and future utility and the intertemporal budget constraint

Answer 13

L3

Question 14

What is 1+Rt in the euler equation

Answer 14

The return on investment of of savings

Question 15

What is beta in the euler equation

Answer 15

the level of impatience

Question 16

what does the euler equation suggest

Answer 16

Euler equation suggests that households in equilibrium and maximise it’s utility smooth consumption so that when they get an additional unit of income they are indifferent between current and future consumption.

Question 17

What does the Euler equation suggest will happen if interest increases

Answer 17

If interest rate increases then the left-hand side must also increase meaning current consumption is reduced saving for future consumption

Question 18

Derive the consumption function from the euler equation and intertemporal budget constraint

Answer 18

L3

Question 19

take derivatives of this consumption function with respect to current, future income and interest and state what these values mean

Answer 19

L3
A positive value means as you increase current income you increase current and future consumption.

The negative value for interest rate means that current consumption decreases as interest increases.

Question 20

The life cycle hypothesis

Answer 20

Fishers model says that consumption depends on lifetime income and people try to achieve a smooth consumption pattern.
LCH says that income varies systematically over the phases of the consumes ‘life cycle’ and saving allows the consumer to achieve smooth consumption

Question 21

Basic model of LCH

Answer 21

he basic model W= initial wealth Y= annual income until retirement (assumed constant) R= number of years until retirement T= lifetime in years
C = (W + RY )/T

Question 22

Assumptions of LCH

Answer 22

zero interest rate and consumption smoothing is optimal

Question 23

How can LCH solve the consumption puzzle

Answer 23

The APC implied by LCH= a(W/Y)+b
Across households wealth does not vary as much as income so high income households should have lower APC than low income households.
Over time aggregate wealth and income grow together causing APC to be consistent

Question 24

Life cycle hypothesis implications

Answer 24

Impact of interest on wealth and therefore consumption
If households smooth consumption tcutting tax for one year would not stimulate consumption

Question 25

Criticisms of LCH

Answer 25

People dont die with 0 net worth people save due to the unpredictability of the future idiosyncratic shocks cause people to lose income

Question 26

Permanent income hypothesis equation

Answer 26

Y=Yp+Yt Current income= permanent income + transitory income

Question 27

Explanation of the permanent income hypothesis

Answer 27

Consumers use savings and borrowings to smooth consumption in response to transitory changes in income

Question 28

How the PIH can solve the consumption puzzle

Answer 28

High income households hold a higher transitory income than low income households APC will be lower in low income hosueholds Over the LR income variation is due to permant income which implies steady APC

Question 30

Policy implications of PIH

Answer 30

If you want to significantly affect household consumption you have to impact permanent income

Question 31

According to the neoclassical model what does investment depend on

Answer 31

MPK Interest Tax rules

Question 32

What does the neoclassical model assume about firms

Answer 32

there are 2 types of firms production firms rent the capital they use for production and rental firms who buy capital to rent out to production firms investment is rental firms buying new capital

Question 33

Profit function of a firm using cobb douglas function

Answer 33

check L5

Question 34

Diagram for the capital rental market

Answer 34

L5

Question 35

Rental firms investment decisions and profit max output

Answer 35

Rental firms invest when the benefit of doing so exceeds cost R/P=aAK^a-1 L^1-a

Question 36

Components of the cost of capital

Answer 36

interest cost depreciation cost capital loss

Question 37

Nominal cost of capital equation

Answer 37

L5

Question 38

Rental Firm profit rate what is R/P

Answer 38

L5 if Profit rate is more than 0 increasing K is profitable R/P is the real rental rate

Question 39

Net investment equation

Answer 39

L5

Question 40

Gross investment equation

Answer 40

L5

Question 41

what is ln re investment function

Answer 41

its a function that shows how net investment responds to the incentive to invest

Question 42

how do investment tax credits affect investment

Answer 42

ITC reduces a firm’s taxes by a certain amount for each pound spent on capital * ITC reduces Pk- increasing the profit rate incentivising investment

Question 43

Tobin's Q

Answer 43

Q= market value of installed capital (D/R discounted dividend)/replacement cost of installed capital q>1 firms buy more capital to raise market value of their firms If q<1 firms do not replace capital as it wears out

Question 44

Stock market and GDP

Answer 44

Reasons for a relationship between stock market and GDP: 1. A wave of pessimism about future profit of capital would: * Cause stock prices to fall * Cause Tobin’s Q to fall * Shift investment function down * Cause a negative AD shock 2. A fall in stock prices would: * Reduce household wealth * Shift consumption function down Modigliani * Cause a negative AD shock 3. A fall in stock prices might reflect bad news about technological processes and LR growth * This means AS and full employment output will be expanding more slowly than expected

Question 45

The role of financing constraints

Answer 45

* Neoclassical theory assumes firms can borrow to buy capital whenever it’s profitable to do so * Financing constraints prevent this even if firms expect high future profits during recession

Question 46

Residential investment:

Answer 46

* New residential investment Ih depends on the relative price of housing Ph/P * Relative house price is determined by supply and demand * Stock of housing Kh

Question 47

residental investment diagrams

Answer 47

L5

Question 48

Inventory investment in a recession

Answer 48

Only about 1% of GDP yet in recession more than half of the spending is due to a fall in this.

Question 49

Motives for holding inventories

Answer 49

1. Production smoothing * Sales fluctuate but firms find it cheaper to produce at a steady rate * When sales < production, inventories rise * When sales > production inventories fall 2. Inventories as a factor of production * Inventories allow some firms to operate more efficiently * Samples for retail sales purposes * Spare parts for when machines break down 3. To prevent loss of sales in the event of higher-than-expected demand 4. Goods not completed yet count as inventory High interest rates higher opportunity cost of holding inventory

Question 50

SR policy implications of the LCH

Answer 50

The monetary mechanism- wealth in the consumption function Transitory income tax changes

Question 51

Criticisms of LCH

Answer 51

Uncertainty Bequest motive transferring wealth to loved ones after death

Question 52

The random walk hypothesis

Answer 52

Hall adds the assumption of rational expectations If PIH applies then consumption takes a random walk changes in consumption should be unpredictable Changes in income/ wealth that are anticipated have already been factored into expected permanent income so will not affect assumption thus only unanticipated wealth or income that alter expected permanent income will change assumption.

Question 53

What does the literature state happens when there are anticipated changes in income with consumption w reference

Answer 53

there is considerable evidence that consumption responds more than consumption smoothing models anticipates. Consumption is less responsive to anticipated income declines. Jappeli and Pistaferri 2010

Question 54

What does literature state happens when income changes are unanticipated

Answer 54

when shocks are permanent consumption is more reactive compared to transitory shocks. In the US there is also evidence that consumers to not revise consumption fully in response to permanent shocks - role of precautionary saving

Question 55

Draw an intertemporal budget constraint to show when borrowing constraints are binding and non binding

Answer 55

L3

Question 56

Stats with relation to precautionary saving w reference

Answer 56

40-45% of savings are due to precautionary motives Carrol and Samwick (1998)

Question 57

response to permanent and transitory income changes according to PIH

Answer 57

consumers spend their permanent income, but they save most of their transitory income.

Question 58

Case Study of tax rebates with relation to the permanent income hypothesis and why this happened

Answer 58

2008 financial crisis congress provided economic stimulus in the form of tax rebates timings of which were based on last 2 digits of national insurance which is random. Data showed the the stimulus had a large impact on spending also theory states the timings of payment should have no difference on spending because permanent income was the same however, timings had a profound impact. Explained by borrowing constraints

Question 59

impact on consumption when changes in income are anticipated vs unanticipated according to theory and whether they're short lived or permanent

Answer 59

Anticipated has already been factored into lifetime resources and permanent income so consumption is unaffected. Unanticipated has not so therefore creates a small lived increase in consumption while permanent creates long-lasting increase.

Question 60

Impact of real interest rates on inventory investment

Answer 60

The real interest rate is the opportunity cost of holding inventories. An increase in the real interest rate increases the cost of holding inventories

Question 61

Impact of a borrower on consumption when interest increases

Answer 61

Certain decrease in initial consumption ambiguous future impact dependent on what is larger income or sub effect

Question 62

Interest rate increase: lender effects on current and future consumption

Answer 62

current consumption => Sub (-) Income (+) => total= ambiguous * Future consumption => Sub (+) Income (+) => total effect is positive

Question 63

Interest rate increase: borrower effects

Answer 63

current consumption => Sub (-); Income (-) => Overall impact < positive * Future consumption=> Sub (+); Income (-) => overall impact = ambiguous.

Question 64

What does the literature state about the income and substitution effect

Answer 64

sub dominates

Question 65

temporary change in income with binding constraints

Answer 65

decrease in consumption 1 to 1 unable to borrow

Question 66

temporary change in income on consumption LCH

Answer 66

minimal change due to smoothing

Question 67

Evidence against PIH and LCH

Answer 67

consumption reacts to anticipated income increases as they faced binding borrowing constraints And retirement sees a sharp drop off in consumption despite being planned

Question 68

Investment function diagram

Answer 68

r y axis investment on x

Question 69

Impact of income changes with binding borrowing constraints

Answer 69

1 to 1 change as they cannot borrow

Question 70

Binding borrowing constraints diagram

Answer 70

L3

Question 71

Corporate income tax impact on investment

Answer 71

I depreciation cost is measured using current price of capital, and the corporate income tax would not affect investment legal definition uses the historical price of capital. If PK rises over time, then the legal definition understates the true cost and overstates profit, so firms could be taxed even if their true economic profit is zero. Thus, corporate income tax discourages investment.