Deck 8: Wealth and Substitution Effects in Labor and Capital Markets

Question 1

As long as both current and future consumption are normal goods, a decrease in the interest rate will result in a drop in savings.

Answer 1

False

Question 2

If you earn income now and expect to live off savings in the future, then a raise now will cause you to save more so long as consumption -- now and in the future -- is a normal good.

Answer 2

True

Question 3

Suppose you know I am only about consumption this year and consumption next year.Suppose also that I have an income this year but do not expect to have an income next year.Explain your answers.​
a.You notice that I save more after the interest rate falls.Can you tell whether "consumption now" is a normal, inferior or Giffen good?
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b.Suppose I also received an unexpected raise at work and you overhear me say: "Cool, I am even Steven.Now that I have my raise, I am just as happy as I was before the interest rate fell and I did not yet have a raise." Without knowing anything more, can you tell whether I consume more or less next year than I would have consumed had neither of the two changes happened?

Answer 3

a. Yes, you can tell. A drop in the interest rate gives rise to a substitution effect that says consume more now. If consumption now actually falls, it means that the wealth effect pushed in the opposite direction (for a decrease in wealth from the compensated to the final budget) -- so consumption now is a normal good.
b. Here, we are staying on the same indifference curve -- but the slope of the budget has become shallower. This implies a move to the right along the indifference curve -- a move to more consumption now and less consumption next year. (This is, of course, just a pure substitution effect.)

Question 4

For decreases in wage taxes, substitution effects put negative pressure on tax revenues while wealth effects put positive pressure on tax revenues.

Question 5

A friend is currently earning income but does not expect to earn income in the future.When the interest rate rose, I observed him saving less.From this, I can conclude that current consumption is an inferior good for my friend.

Question 6

When tastes over current and future consumption take the Cobb-Douglas form, interest rates have no impact on savings when income is earned in the current period but not in the future.

Question 7

Taxing savings in ways that lower the interest rate received by savers will lower savings.

Question 8

If leisure is an inferior good, then an increase in wages will cause workers to work more.

Question 9

Because workers tend to work more when their after-tax wage increases, the government can increase tax revenue by cutting taxes.​

Question 10

When the elasticity of substitution in the constant elasticity of substitution utility function lies above 1, an increase in the interest rate will cause a saver to save less.

Question 11

Assuming no kinks in indifference curves and assuming our usual assumptions about tastes hold, someone who currently neither saves nor borrows will begin to borrow when the interest rate falls.

Question 12

Suppose you own a stock portfolio composed of shares in firms that are part of the financial services industry.You don't work - all you do is plan your consumption now and when you retire, and the only asset you have is your stock portfolio.In this problem, model your decisions in a graph with "consumption now" on the horizontal axis and "consumption at retirement" on the vertical.Throughout, assume that the long run rate of return of investment is r over the period from now to retirement.
a.Graph your initial budget constraint - and indicate where in your graph your endowment point lies as well as what the slope of the budget constraint is.
b.This morning, you woke up to find that the current financial crisis has wiped out some of the firms in your stock portfolio.As a result, your portfolio is only worth half of what it was yesterday.Assuming that the long run rate of return r remains unchanged, what has just happened to your budget constraint?
c.Assuming that consumption now and in the future is always a normal good, will you cut down on your consumption plans now?
d.Now suppose I offer you a deal: I will give you enough cash to raise your current (financial) wealth back to what it was yesterday, but in exchange you agree to give me half of any return in your investments when you retire.You carefully analyze the deal and calculate that, under this deal, you could in fact just afford to consume the same bundle (but not strictly more) as you would without the deal.Will you accept the deal?
e.Does your answer to (d) depend on our assumption that consumption is always a normal good?
f.Can you tell whether, if you accept the deal, you will consume more than you otherwise would have? What does your answer depend on?
g.Can you tell whether, if you accept the deal, you consume more now than you had planned yesterday before the financial crisis wiped out half your wealth? What does your answer depend on?

Question 13

In the U.S., everyone has to pay social security taxes on labor income until pre-tax income reaches a certain amount after which no additional taxes are due.Consider the case of workers A, B and C who have 60 hours of leisure per week and who earn an hourly wage of $40.Suppose the social security tax is 50% up to a pre-tax weekly income of $1,200 and then falls to zero for any income above $1,200 per week.Assume tastes are homothetic.
a.Worker A is observed to work 40 hours per week under this tax system.Is he working more or less than he would if the system were abolished?
b.Worker B is observed to work 30 hours a week under this tax system.Is he working more or less than he would if the system were abolished?
c.Worker C is observed to work 20 hours per week under this system.Is he working more or less than he would if the system were abolished?
d.Could any of the three workers above share exactly the same tastes?
e.For which of these workers is there no deadweight loss from the tax?

Question 14

The more substitutable current consumption is with future consumption, the more likely it is that an increase in the interest rate will cause an increase in savings.

Question 15

In a model of consumption and leisure, a drop in the wage will cause workers to work more if tastes are quasilinear in consumption.

Question 16

In a model of consumption and leisure, a drop in the wage will cause workers to work less if tastes are quasilinear in leisure.

Question 17

In a model with leisure hours and a composite consumption good, you cannot tell whether workers will work more or less if tastes are quasilinear in the consumption good.

Question 18

The amount of work a person will do as wage increases depends entirely on the size of the wealth effect.

Question 19

When tastes over current and future consumption are characterized by Cobb-Douglas utility functions, a borrower who has no income now and all income in the future will borrow more when the interest rate falls.