Suppose you expect to earn $10 this year and $10 next year. Each dollar you earn this year can be be either spent, or saved at an interest rate of 10%. If you want to spend more than $10 this year, you can borrow money at 10% interest and repay it next year. Next year, you plan to pay o
your debts (if any), then spend all your earnings and all your savings (if any).
- Draw your budget line between “dollars spent this year” and “dollars spent next year”.
- Suppose the government imposes a 50% income tax on all your earnings this year and next year (not including your interest earnings). Draw your new budget line.
- Suppose the government imposes a 50% sales tax on everything you buy this year and next year. Draw your new budget line.
- Suppose the government imposes a 50% income tax on all your earnings this year and next year, including your interest earnings. Draw your new budget line.
- True or False: If interest earnings are not subject to income tax, then an income tax and a sales tax will lead you to spend exactly the same amount both this year and next year.
Suppose you allocate all your wealth to “housing” and “savings”. Housing costs $40 per square foot. You have $100,000 in wealth and have elected to build a 1000 square foot house.
- Draw your budget line between housing (on the horizontal axis) and savings (on the vertical). Draw the indifference curve you are on and illustrate your optimal consumption.
- Now suppose the price of housing falls to $30 per square foot. Draw your new budget line. (Hint: You can keep your existing house if you want to.)
- True or False: The fall in housing prices makes you happier.
- Assume that housing is an inferior good and illustrate the substitution and income effects from a fall in housing prices.
- True or False: If housing is an inferior good, then in this problem the substitution effect must be larger than the income effect.