Problem Set Unit 10 - CORE ebook.
Section 1: Multiple choice, note that more than one answer (or none) may be correct.
Q1. The diagram depicts Julia’s choice of consumptions in periods 1 and 2. She has no income in period 1 and
an income of $100 in period 2. In scenario 1 the interest rate is 10%, while in scenario 2 it is 78%. Based on this
information, which of the following statements is correct?
a. Julia is able to consume more in period 2 at G under scenario 2 than at E under scenario 1, as her
savings earn a higher interest in the former than in the latter.
b. Julia consumes less in period 1 at G under scenario 2 than at E under scenario 1, as she is less impatient
at G.
c. The substitution and income effects of the interest rate rise partially offset each other, resulting in lower
consumption in period 1 under scenario 2.
d. For this income scenario of no income in period 1 and an income of $100 in period 2, Julia is
unambiguously worse off with an interest rate rise.
Q2. The diagram depicts four possible feasible frontiers for Marco, who has $120 worth of grain in period 1
and no income in period 2. In scheme 1, he can store the grain that he does not consume in period 1. This results
in some loss of the grain due to pests and rotting. In scheme 2, he can sell the grain that he does not consume
and lend the money. In scheme 3, he can invest the remaining grain (e.g. plant it as seed). Finally in scheme 4,
he can invest the entire amount of grain and borrow against his future income. Based on this information, which
of the following statements is correct?
a. The depreciation from storage is 30%.
b. The lending rate is 24%.
c. The rate of return from purely investing grain is 40%.
d. The borrowing rate is 12%.
Q3. Which of the following statements about the banking system is correct?
a. The policy rate is the rate at which the central bank lends in the money market.
b. The policy rate is determined by the supply and demand of the money market.
c. The bank lending rate is the rate at which the central bank lends to commercial banks.
d. The spread represents how the central bank’s money is distributed amongst the commercial banks.
Consumption now ($)
0
0
168
144
80
Consumption later ($)
140120
Marco’s status quo
Feasible consumption frontier
(scheme 4: invest grain and borrow)
Feasible consumption frontier
(scheme 3: invest grain)
Feasible consumption frontier
(scheme 2: lend)
Feasible consumption frontier
(scheme 1: store grain)
Section 2: For this section, please make some notes that you will then be able to discuss in class.
Q1. Exercise 10.2 ‘Income and substitution effects’
1. Use Figure 10.4 to show that the difference in current consumption at the lower and higher interest rate (at E
and G), namely $23, is composed of an income effect and a substitution effect. It will be helpful to review
income and substitution effects from Unit 3 before doing this.
2. Why do the income and substitution effects work in the same direction in this example?
Q2. Exercise 10.3 ‘An increase in the interest rate’
1. Use a diagram like Figure 10.4 to show the income and the substitution effects of an increase in the interest
rate for Marco who receives his endowment today.
2. Compare these effects with those for Julia in Exercise 10.2 and explain your results.
Q3. Exercise 10.6 ‘Interest rates and consumption spending’
Think about the income and substitution effects of a rise in the interest rate, as analysed in Exercise 10.2 and
10.3. Comment on whether a rise in the interest rate would be expected to reduce consumption expenditure in
an economy in which a proportion of households are like Julia, and a proportion are like Marco.
