. Consider an economy that is composed of identical individuals who live for two

Question

. Consider an economy that is composed of identical individuals who live for two periods. These individuals have preferences over consumption in periods 1 and 2 given by U = ln(C1) + ln(C2). They receive an income of 100 in period 1 and an income of 50 in period 2. They can save as much of their income as they like in bank accounts, earning an interest rate of 10% per period. They do not care about their children, so they spend all their money before the end of period 2.

Each individual’s lifetime budget constraint is given by C1 + C2/(1 + r) = Y1 + Y2/(1 + r). Individuals choose consumption in each period by maximizing lifetime utility subject to this lifetime budget constraint.

    What is the individual’s optimal consumption in each period? How much saving does he or she do in the first period?

    Now the government decides to set up a social security system. This system will take $10 from each individual in the first period, put it in the bank, and transfer it to him or her with interest in the second period. Write out the new lifetime budget constraint. How does the system affect the amount of private savings? How does the system affect national savings (total savings in society)? What is the name for this type of social security system?

Explanation / Answer

The lifetime income of an individual = 100 + 50 = 150

Now he can consumes this income in two period - c1 and c2 and interest rate on his savings is 10%, therefore his consumption basket is defined as

c1 + c2/(1+r) = y1 + y2/(1+R) = 100 + 50/1.1 = 145.45

c2 = (145.45 - c1) * (1.1) ........... (1)

Now MUc1 = 1/c1

MUc2 = 1/c2

equating the ration of marginal utilities with the prices of consumption of two periods (as the price of consumption in first period is (1+R) while that of period 2 is 1) thus

c2/c1 = 1+R = 1.1

c2 = 1.1 * c1 ............ (2)

Inserting the value of c2 from (2) in (1), we get

1.1 * c1 = (145.45 - c1) * (1.1)

2c1 = 145.45

c1 = 145.45 / 2 = 72.73

c2 = 1.1 * 72.73 = 80

b. When government takes away $10 from the first period and add it to the income of a consumer in second period then the income of individual is as follows

Y1 = 100 - 10 = 90

Y2 = 50 + 10 + (10% of 10) = 61

Now Equation (1) is modified as

c1 + c2/1.1 = 90 + 61/1.1 = 90 + 55.45 = 145.45

c2 = (145.45 - c1) * 1.1

which is same as that of equation (1)

Thus there would be no change in equilibrium values except that $10 is a compulsory savings of an individual thus reducing the private savings from (100 - 72.73 = 27.27) to 17.27

This type of savings is known as Providend fund.

Related Questions

Navigate

• Browse (All)
• Browse #
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.