Question

a) Suppose that Julia and Marco both have £100 in the current period but anticipate no income in the future. Marco is more impatient than Julia and they both face an interest rate for lending and borrowing equal to 10%. What are the differences in the way that Julia and Marco would allocate their consumption between the current period and the future?

b) What factors influence the degree of consumption smoothing in an economy?

c) Explain how the central bank can use the interest rate to increase output and employment in the economy. Consider carefully the effect on both consumption and investment.

Answer 1

Solution A

Since Marco is more impatient than Julia he will smooth out consumption by utilization of money rightaway rather than saving for later.

However Julia woukd save now and consume later.

Solution B

Degree of consumption smoothing is affected by impatience to consume and diminishing returns. Future income and interest rates also do affect it.

Solution C

Central bank uses expansionary monetary policy to increase real GDP or output Using decrease in interest rates, decrease in cash reserve ratio for banks and buying government securities . As result, prices and aggregate demands rise. Also fall in interest rates causes rise in investment due to money supply and hence consumption increases.