Question 1

Suppose a consumer faces a kinked budget constraint because the borrowing interest rate $$r_2 is $$higher than the lending interest rate $$r_1. $$Which of the following statements is TRUE about the consumer's optimal consumption choice if they are initially a saver and receive a temporary tax cut today (with future taxes increased to offset it)?

Accepted Answer

The consumer will increase current consumption and be better off, unlike Ricardian equivalence in a perfect credit market.

Question 2

In the two-period model with credit market frictions, the consumer's lifetime budget constraint for a borrower is given by:

Accepted Answer

$$c + \frac{c'}{1 + r_2$} = y - t + \frac{y' - t'}{1 + r_2$}$$

Question 3

Which of the following best describes the effect of a decrease in the maximum amount $$d$$ that banks are willing to lend to borrowers in the general equilibrium model with credit market imperfections?

Accepted Answer

It tightens borrowing constraints, reduces demand for private sector credit, and decreases the real interest rate.

Question 4

Suppose the government increases its debt $$B in $$the general equilibrium model with credit market imperfections. What is the most likely effect on the real interest rate and the welfare of borrowers?

Accepted Answer

The real interest rate increases and borrowers' welfare rises because the government effectively relaxes their borrowing constraint.

Question 5

In a credit market with asymmetric information, banks cannot distinguish between good and bad borrowers. If the fraction of good borrowers $$a$$ decreases, what happens to the default premium and the loan interest rate $$r_2$$?

Accepted Answer

The default premium increases and $$r_2$$ rises.

Question 6

Consider a two-period model with limited commitment and a collateral constraint. If the value of collateral (e.g., house price $$p_H) $$falls, what is the effect on a constrained borrower's consumption choices?

Accepted Answer

The borrower must reduce current consumption, but future consumption remains unchanged.

Question 7

In the insurance model with uncertainty, suppose the probability of receiving income $$y is$$ $$1-\alpha$$ and the probability of receiving zero income is $$\alpha. If $$private insurance is available and actuarially fair, what is the equilibrium condition for the insurance contract (premium $$p$$, benefit $$b$$)?

Accepted Answer

$$(1-\alpha)p = \alpha b$$

Question 8

Which of the following is a key difference between a pay-as-you-go and a fully funded social security program?

Accepted Answer

A pay-as-you-go program is funded by taxes on the working population, while a fully funded program is based on individual savings.

Question 9

Suppose the population growth rate $$n is $$greater than the real interest rate $$r in a $$pay-as-you-go social security system. What is the implication for the welfare of future generations?

Accepted Answer

The rate of return on social security is higher than the market interest rate, so future generations are better off.

Question 10

During the 2007-2008 financial crisis, which of the following best explains the observed increase in the spread between loan and deposit interest rates?

Accepted Answer

A decrease in the fraction of creditworthy borrowers increased the default premium.

Question 11

If a government introduces a transfer program to insure against income loss (as during COVID-19), and finances it with lump-sum taxes, what is the optimal arrangement for maximizing consumer welfare?

Accepted Answer

Consumers with income pay a tax, and those without income receive a transfer, balancing the budget.

Question 12

Which of the following is NOT a direct consequence of credit market imperfections?

Accepted Answer

Ricardian equivalence always holding.

Question 13

In the context of limited commitment, what role does collateral play in credit markets?

Accepted Answer

It provides an incentive for borrowers not to default by limiting borrowing to the value of collateral.

Question 14

Given the following consumer's current-period budget constraint: $$c + s = y - t$$, what does each variable represent?

Accepted Answer

$$c is $$consumption, $$s is $$saving, $$y is $$income, $$t is $$lump-sum tax.

Question 15

Which of the following best describes the effect of a decrease in the fraction of creditworthy borrowers $$a on $$the budget constraint of a good borrower in a market with asymmetric information?

Accepted Answer

The budget constraint swivels inward, reducing current consumption and borrowing.

Question 16

In a two-period model with a collateral constraint, the maximum amount a consumer can borrow is limited by:

Accepted Answer

The value of their collateral times the future price of the collateral good.

Question 17

Which of the following is a plausible real-world example of limited commitment in credit markets?

Accepted Answer

Banks requiring a down payment and using a house as collateral for a mortgage loan.

Question 18

In the insurance model, if the consumer's utility function is concave, what does this imply about their attitude toward risk?

Accepted Answer

They are risk-averse and prefer to smooth consumption across states.

Question 19

Which of the following statements about Ricardian equivalence is correct in the presence of credit market imperfections?

Accepted Answer

Ricardian equivalence may not hold because consumers cannot always borrow or lend freely.

Credit Market Imperfections, Financial Crises, and Social Security: Study Notes

Study Guide - Practice Questions

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