Credit Frictions, Financial Crises & Social Security

Question 1

What is a risk premium?

Answer 1

rL = rd + π

Question 2

What is the effect of a tax cut for a consumer consuming at the endowment point because of a risk premium on borrowing rate and what does this imply?

Answer 2

• E1 → E2
• Because consumption is at the endowment point both before and after the tax cut, period 1 consumption increases by the amount of the tax cut, -Δt
  
  • This implies that the Ricardian equivalence does not hold
• This is essentially a low rate government loan to consumers - the consumer would like to consume at point G is they could borrow at r1
  
  • Giving the consumer a tax cut of -Δt with a corresponding future tax liability of -Δt(1+r1) is just like is just like having the government loan the consumer -Δt at an interest rate of r1

Question 3

What is the lifetime budget constant with a housing collateral restraint?

Answer 3

c + c’/(1+r) = (y-t) + (y’ - t’ + pH)/(1+r) = we*

Question 4

What is the collateral constant?

Answer 4

• c ≤y - t + (pH/(1+r))
• Current period consumption can be no greater than current disposable income plus the amount that can be bored by the consumer by pledging the future value of the house as collateral
• From -s(1+r) ≤pH
• And substituting into s = y - t - c

Question 5

For c = c’, what are the steps to determining the consumers optimal allocation?

Answer 5

• Find we
• Find c
• Find s
• Check if constant is binding or not: s

Question 6

If taxes change with a non-binding constraint consumers will…

Answer 6

not change allocation and just change savings

Question 7

If taxes change with a binding constraint consumers will…

Answer 7

change allocation and ricardian equivalence does not hold

- Because s = 0, c = y - t1 vs c = t - t2

Question 8

What does a non feasible amount of savings always mean for perfect compliments?

Answer 8

Corner solution, CANNOT be on budget constraint

Question 9

What does a decrease in the number of credit worth borrowers result in graphically?

Answer 9

Increased slope for borrowers side of endowment

Question 10

Where does a borrower with normal consumption preferences consume when facing a credit constant?

Answer 10

At the credit limit - on the constraint

Question 11

Where does a borrower with perfect complementary consumption preferences consume when facing a credit constant?

Answer 11

Corner solution - not on the constraint (almost always)