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Quiz: Assignment 2

Started: 1 Jun at 19:50

Quiz instructions

Question 1

Saving and Borrowing

Question 1 a)

Suppose there are two periods (1 is now and 2 is later). Your contemporaneous utility function is log c and you discount utility in period 2 with discount factor 0 ≤ δ < 1. In both periods you have income c. There is no bank. So if you want to save money, then you do not earn any interest. If you would like to borrow money then you can ask your rich mum. She is willing to lend you money in period 1, which you have to pay back without interest in period 2. Which of the following statements on your optimal borrowing or saving decision is correct?

You will borrow some money from your mum. The amount you borrow is always greater than zero and smaller than c.

You will borrow money from your mum which can be (depending on your discount factor) as much as your total income in period 2.

You will save a positive amount of money that depends on δ.

You will not borrow or save any money to fully smooth consumption.

Question 2

Saving and Borrowing

Question 1 b)

Suppose there are two periods (1 is now and 2 is later). Your contemporaneous utility function is log c and you discount utility in period 2 with discount factor 0 ≤ δ < 1. In both periods you have income c. Now there is a bank that is willing to lend or to store money. The bank charges interest at rate on loans and pays interest at the same rate on deposits. (You had a fight with your mum and she is no longer willing to lend you any money.) Which statement about your optimal saving-borrowing decision is correct.

If 1 + r > 1/δ, then you will save some money.

If r > 1 - δ, then you will save some money.

If δ > 1/(1 + r), then you save some money.

If r > δ, then you will save some money.

Question 3

Saving and Borrowing

Question 1 c)

Suppose there are two periods (1 is now and 2 is later). Your contemporaneous utility function is log c and you discount utility in period 2 with discount factor 0 ≤ δ < 1. In both periods you have income c. Now there is a bank that is willing to lend or to store money. The bank charges interest at rate r on loans and pays interest at the same rate on deposits. (You had a fight with your mum and she is no longer willing to lend you any money.) Unfortunately, at the beginning of period 1, you damage the neighbor's expensive BMW playing backyard cricket and you have to pay z dollars for the repair (in period 1). Which statement about optimal saving and borrowing behavior is correct?

If r > 1 - δ, you will still save some money.

Since the interest rate and the discount rate are still the same, the payment to the neighbor will not change your optimal level of borrowing or saving.

If 1 + r > 1/δ, then you will borrow some money.

Regardless of the values of r, δ and z you will borrow some money to make up for the shortfall such that you achieve the same consumption in both periods.

Question 4

Saving and Borrowing

Question 1 d)

Suppose there are two periods (1 is now and 2 is later). Your contemporaneous utility function is log c and you discount utility in period 2 with discount factor 0 ≤ δ < 1. In both periods you have income c. Now there is a bank that is willing to lend or to store money. The bank charges interest at rate r on loans and pays interest at the same rate on deposits. (You had a fight with your mum and she is no longer willing to lend you any money.) Unfortunately, at the beginning of period 1, you damage the neighbor's expensive BMW playing backyard cricket, and you have to pay z dollars for the repair (in period 1).

Assume δ = 0.8, c = 20,000, r = 0.1, and z = 10,000. How much money will you save or borrow?

Borrow 5,656.57 Dollars.

The correct answer differs at least by a Dollar from the other answers given.

Save 1,538.46 Dollars

Save 6,577.54 Dollars

Question 5

Independent Question: Prospect Theory

2) Prospect Theory is an alternative theory to Expected Utility Theory, which is used in standard finance and economics to model how people make choices under risk and uncertainty. Prospect Theory is used to explain a variety of observed behavior, which violates Expected Utility Theory. Which of the following violations does Prospect Theory not explain?

People play the lottery and at the same time buy insurance.

People are motivated by changes of their wealth relative to a reference point rather than by total life-time wealth.

People's preferences over two assets might change depending on whether an irrelevant third asset is on offer or not.

People behave differently in the same situation, depending on if they perceive a risk as securing a potential gain or as preventing a sure loss.

Question 6

Independent Question: Trade and Equilibrium

3) Take the situation from the lecture where two people have very different endowments in two periods ( 1 is now and 2 is later). Tina has incomes $ 99 today and $ 1 later, while Lenny has $ 1 today and $ 99 later. The Edgeworth box below depicts the situation with indifference curves for both.

Which statement about the graph and the situation is wrong?

If Lenny and Tina meet, bargain and write some time-contingent contracts, then they might end up in any allocation within the shaded lens, where their indifference curves tough.

The Edgeworth box shows that bilateral bargaining (without transaction cost) as well as decentralized complete markets with perfect competition yield pareto-efficient outcomes.

If there is a bank out there that borrows and lends money at the same rate and makes zero profits, then the pareto-optimal allocation c* is reached.

All allocations in the shaded area make both better off, than the endowment and hence are pareto optimal.

Question 7

Independent Question: Insurance

4) Ayasha is a risk-averse expected utility maximizer with wealth c and faces the risk of a natural disaster destroying her house valued at D dollars. The probability of such a natural disaster to occur is π. An insurance company offers an insurance policy, where Ayasha can choose how much of the potential damage she wants to insure. The premium p is greater than the probability of the disaster occurring π. Which of the following statements about Ayasha's optimal insurance purchase is wrong?

Whether Ayasha increases the amount of insurance when the premium is reduced depends on a substitution effect (positive) and a wealth effect (, which can be positive or negative depending on the risk-preferences).

Constant Relative Risk Aversion is a necessary condition for increasing wealth to reduce the amount of insurance Ayasha buys.

Ayasha will not fully insure the value of her house.

Ayasha might not buy any insurance if the premium is above a certain level or if she has Constant Relative Risk Aversion and is sufficiently rich.

Question 8

Independent Question: First FWT

The First Fundamental Theorem of Welfare Economics states that markets lead to efficient allocations, as long as certain conditions are met. Which of the following imperfections do not violate the requirements of the first FWT.

Banks manage to charge higher interest on loans than they pay on deposits.

Banks do not know individual's risk preferences.

A venture-capital company funding start-ups cannot observe which ones are actually likely to succeed.

An insurance company selling car insurance cannot observe if a customer is driving carefully.