EVALUATION GUIDELINES - Take-home examination

Component of continuous assessment

GRA 65161
Economics for Finance

Department of Economics

Start date: 11.12.2020 Time 16:00

Finish date: 11.12.2020 Time 19:00

For more information about formalities, see examination paper.

 Final Exam-2020

GRA 6516-Economics for Finance

Intertemporal Consumption

1. Consider a consumer that is choosing consumption today (Ct ) and to-

morrow (Ct+1 ) by maximizing lifetime utility

U = log(Ct ) + β log(Ct+1 )

where β is a discount rate. The consumer is facing the following sequential

budget constraints
Ct + St = Yt

Ct+1 + St+1 = Yt+1 + (1 + r )St

where St is the savings (it could be negative) at t and r is the rate of interest.

(a) Compute the intertemporal budget constraint for the household.

Answer. We know that St−1 = 0 and also that there is no bequest.

Hence St+1 = 0. The budget constraint can be represented by

Ct+1 Y
Ct + = Yt + t+1
(1 + r ) (1 + r )

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(b) Derive the Euler equation. Explain the economic intuition behind
this equation.

Answer. In order to derive the Euler equation, we solve the in-

tertemporal consumption problem. In short, we maximize

U = log(Ct ) + β log(Ct+1 )

subject to the budget constraint:

Ct+1 Y
Ct + = Yt + t+1
(1 + r ) (1 + r )
The Lagrangian of this problem is as follows
! "
Ct+1 Yt+1
L = log(Ct ) + β log(Ct+1 ) − λt Ct + − Yt −
(1 + r ) (1 + r )
Maximizing L gives the following FOC

∂L 1
= − λt = 0
Ct Ct
∂L β λt
= − =0
Ct+1 Ct+1 (1 + r )

∂L C Y
= Ct + t+1 − Yt − t+1 = 0
λt (1 + r ) (1 + r )
From the two FOCs we get the Euler equation:
Ct+1
Ct =
β (1 + r )
The Euler equation shows how the household allocates consump-
tion across periods. The marginal cost of postponing consumption
today should be equal to the marginal benefit of consuming more
tomorrow.

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(c) Graphically, depicts the optimality condition. Carefully, label the
intercepts of the budget constraint.

Answer.

(a) To find the intercept, we find the maximum level of consump-

tion that could be obtained in each period

i. From the budget constraint we set Ct = 0 and find that

the maximum level of Ctmax
+1 = Yt (1 + r ) + Yt+1

ii. From the budget constraint we set Ct+1 = 0 and find that
Yt+1
the maximum level of Ctmax = Yt + (1+r )

(b) Using a graph, analyze the effect of an increase in Yt .

Answer.

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 i. As shown by the Euler equation, the relative consump-
tion is independent from the level of income. Hence any
change in either Yt or Yt+1 should affect the level of Ct
and Ct+1 in the same proportion.
ii. From the Euler equation and the budget constraint it is
possible to derive the level of Ct and Ct+1
Ct+1 C Y
+ t+1 = Yt + t+1
β (1 + r ) (1 + r ) (1 + r )
! "
β (1 + r ) Yt+1
Ct+1 = Yt +
(1 + β ) (1 + r )
! "
1 Yt+1
Ct = Yt +
(1 + β ) (1 + r )

Demand for Insurance

2. Consider a risk averse person with current wealth of 100,000

who faces a 25 percent chance of losing her 20,000 automobile

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through theft next year. Suppose this person has logarithmic ex-
pected utility, ie : U (W ) = log(W ).

(a) Compute the expected utility for this person without in-
surance.
Answer. The expected utility with no insurance

EUni = 0.75 log(100, 0000 + 0.25 log(100, 000 − 20, 000)

EUni = 11.45

(b) This person is clearly better off by purchasing a fair in-

surance. Determine the maximum insurance premium (I)
this person is willing to pay.
Answer. With a fair insure we have that L=K ( using the
notation of the lecture), hence,

EUi = log(100, 000 − I )

where I is the insurance premium. To find the maximum

amount we equalize the two expected utilities

log(100, 000 − I ) = 11.4571

which gives a value of I = 5, 429.

Industry Equilibrium

3. Supose all firms in an industry have the same supply curve

given by Si ( p) = p/4.

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(a) Plot and label the four industry supply generated by these
firms, if there are 1, 2, 3, 4 firms operating in the industry.

Answer.

i. Aggregated Supply curve is given by Si ( p) = ∑iN=1 si ( p)

ii. S1 ( p) = ∑1i=1 si ( p) = p/4, S2 ( p) = ∑2i=1 si ( p) =

2p/4,S3 ( p) = ∑3i=1 si ( p) = 3p/4, and S4 ( p) = ∑4i=1 si ( p) =
p.
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In the figure below we plot each curve p = 4y, p = 2 y,
p = 43 y, and p = 44 y summing horizontally.

(b) If all firms had a cost structure such that if the price was
below 3 NOK, they would be losing money, what would
be the equilibrium price, output and number of firms in
the industry if the market demand was equal to D ( p) =
2.0.

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 Answer. For 1 and 2 firms in the industry, the equilibrium
price is above 3. To check this compute the following

i. It is S( p) = D ( p) = ∑1i=1 si ( p) = p/4 = 2 so p = 8 in
the case of one firm.

ii. It is S( p) = D ( p) = ∑2i=1 si ( p) = 2p/4 = 2 so p = 4

in the case of two firms.

iii. It is S( p) = D ( p) = ∑3i=1 si ( p) = 3p/4 = 2 so p = 2.7

in the case of three firms.

Hence, the equilibrium number of firms is two and the

equilibrium price is 4, the quantity produced is 2

(c) What if the identical conditions as above held except that

the market demand was equal to D ( p) = 6 − p? Compute
the equilibrium price, output and number of firms in the
industry.

Answer. Now, the demand has increased.

i. It is S( p) = D ( p) = ∑1i=1 si ( p) = p/4 = 6 − p so
p = 24/5 = 4.8 in the case of one firm.

ii. It is S( p) = D ( p) = ∑2i=1 si ( p) = 2p/4 = 6 − p so

p = 4 in the case of two firms.

iii. It is S( p) = D ( p) = ∑3i=1 si ( p) = 3p/4 = 6 − p so

p = 3.42 in the case of three firms.

iv. It is S( p) = D ( p) = ∑3i=1 si ( p) = p = 6 − p so p = 3
in the case of four firms.

Hence, the number of firms will be 4, the equilibrium price

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 is p = 3 and total production 3.

Monetary Policy

4. Consider a Central Bank that is trying to stabilize output in re-

sponse to an expansionary fiscal policy implemented by the gov-
ernment.

(a) Explain how a Central Bank should act to stabilize out-

put? What are the direct and indirect effects on the econ-
omy as a result of monetary policy.

Answer. An expansionary fiscal policy is a positive shock

to Gt . Hence, a positive IS shock. A positive IS shock will
result in a shift in the IS and AD curves, and therefore
an increase in output, price level and interest rates. Since
f
there is no change in Yt this will result in a positive output
gap, where in the short run equilibrium output is more
than the optimal. To counteract monetary policy need to
reduce money supply. A decrease in money will shift the
LM and AS curves to point where output returns to the
level under flexible prices. By reduced money supply the
CB managed to bring output to its original level but inter-
est rate ended up rising relative to its initial level. As a
result consumption and investment fall.

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(b) Now suppose the Central Bank is interested in stabilizing
prices. Explain how the economy will react to this policy.

Answer. As seen before the CB achieved output and price

stability by reducing money supply in response to a pos-
itive IS shock. Hence, we can think as if the CB faces a
horizontal effective aggregate demand ADte = P̄t . Hence,
given a positive shock the the CB keeps the AD at its orig-
inal level, and therefore it is the interest rate that needs to
increase to keep output at the desired level. This is how
Central Banks communicate monetary policy by describ-
ing how interest rates will adjust as a result of shocks.

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