Felice lives and works for two periods. In the first period, she earns 220 coconuts and in the second period, she earns 350 coconuts. In each period, she pays 20 coconuts in taxes.Suppose that Felice can save or borrow from a bank at the same interest rate of 10%. Suppose also that she likes to consume today 240 coconuts. On the graph below draw her budget constraint including both intercepts, her endowment point including its coordinates, and use an indifference curve to show her optimal consumption point and its coordinates.Suppose that the government cuts taxes by 10 coconuts and that, to pay back its debt, in the future period it raises taxes by 11 coconuts (the 10 coconuts plus the 10% interest on its debt of 10 coconuts, which is 1 coconut). What is the effect of the government’s action on Felice’s current consumption and welfare? Does the Ricardian equivalence hold? Explain!Now suppose that the economy enters a recession, and some people begin to default on their loans. Banks estimate that about 4% of lenders will default. Assuming that the deposit rate stays at 10%, what lending rate will they charge to stay in business? Round to the closest first decimal.Suppose the recession happened before the tax cut. Redraw Felice’s budget constraint and her endowment point during the recession.Show graphically what will happen to Felice’s optimal consumption bundle and explain how the recession affected her current consumption and welfare and why.Now suppose that the government gave the same tax cut as in part (b). Show graphically what will happen to Felice’s optimal consumption bundle.What is the effect of the government’s action on Felice’s current consumption and welfare? Does the Ricardian equivalence hold? Explain!

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Personal Finance

13th Edition

ISBN:9781337669214

Author:GARMAN

Publisher:GARMAN

Chapter3: Financial Statements, Tools, And Budgets

Section: Chapter Questions

Problem 3FPC

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Felice lives and works for two periods. In the first period, she earns 220 coconuts and in the second period, she earns 350 coconuts. In each period, she pays 20 coconuts in taxes.
1. Suppose that Felice can save or borrow from a bank at the same interest rate of 10%. Suppose also that she likes to consume today 240 coconuts. On the graph below draw her budget constraint including both intercepts, her endowment point including its coordinates, and use an indifference curve to show her optimal consumption point and its coordinates.
2. Suppose that the government cuts taxes by 10 coconuts and that, to pay back its debt, in the future period it raises taxes by 11 coconuts (the 10 coconuts plus the 10% interest on its debt of 10 coconuts, which is 1 coconut). What is the effect of the government’s action on Felice’s current consumption and welfare? Does the Ricardian equivalence hold? Explain!
3. Now suppose that the economy enters a recession, and some people begin to default on their loans. Banks estimate that about 4% of lenders will default. Assuming that the deposit rate stays at 10%, what lending rate will they charge to stay in business? Round to the closest first decimal.
4. Suppose the recession happened before the tax cut. Redraw Felice’s budget constraint and her endowment point during the recession.
5. Show graphically what will happen to Felice’s optimal consumption bundle and explain how the recession affected her current consumption and welfare and why.
6. Now suppose that the government gave the same tax cut as in part (b). Show graphically what will happen to Felice’s optimal consumption bundle.
7. What is the effect of the government’s action on Felice’s current consumption and welfare? Does the Ricardian equivalence hold? Explain!

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