Econ 3024 Assignment 1 (Final Version)

Spring Semester, 2016
Due Date: 4:30pm Tuesday, 1st March, 2016.
Econ 3024 Assignment 1

1. Suppose a share is expected to pay a dividend of $1,000 next year, and the real value of dividend
payments is expected to increase by 3% per year forever.
a. What is the current price of the stock if the real interest rate is expected to remain
constant at 5%? At 8%?
Now suppose that people require a risk premium to hold stocks.
b. Redo the calculation in part (a) if the required risk premium is 8%
c. Redo the calculation in part (a) if the required risk premium is 4%
d. What do you expect would happen to stock prices if the risk premium decreased
unexpectedly? Explain in words.
2. Consider a consumer who lives for three periods: youth, middle age and old age. When young,
the consumer earns $20,000 in labor income. Earnings during middle age are uncertain; there is
a 50% chance that the consumer will earn $40,000 and a 50% chance that the consumer will
earn $100,000. When old, the consumer spends savings accumulated during the previous periods.
Assume that inflation, expected inflation, and the real interest rate equal zero. Ignore taxes for
this problem.
a. What is the expected value of earnings in the middle period of life? Given this number,
what is the present discounted value of expected lifetime labor earnings? If the
consumer wishes to maintain constant expected consumption over her lifetime, how
much will she consume in each period? How much will she save in each period?
b. Now suppose the consumer wishes, above all else, to maintain a minimum consumption
level of $20,000 in each period of her life. To do so, she must consider the worst
outcome. If earnings during middle age turn out to be $40,000, how much should the
consumer spend when she is young to guarantee consumption of at least $20,000 in
each period? How does this level of consumption compare to the level you obtained for
the young period in part (a)?
c. Given your answer in part (b), suppose that the consumers earnings during middle age
turn out to be $100,000. How much will she spend in each period of life? Will
consumption be constant over the consumers lifetime? (Hint: When the consumer
reaches middle age, she will try to maintain constant consumption for the last two
periods of life, as long as she can consume at least $20,000 in each period.)
d. What effect does uncertainty about future labor income have on saving (or borrowing)
by young consumers?
Spring Semester, 2016

Due Date: 4:30pm Tuesday, 1st March, 2016.
3. Suppose that every consumer is born with zero financial wealth and lives for three periods: youth,
middle age, and old age. Consumers work in the first two periods and retire in the last one. Their
income is $5 in the first period, $25 in the second, and $0 in the last one. Inflation and expected
inflation are equal to zero, and so is the real interest rate.
a. What is the present discounted value of labor income at the beginning of life? What is
the highest sustainable level of consumption such that consumption is equal in all three
periods?
b. For each age group, what is the amount of saving that allows consumers to maintain the
constant level of consumption found in part (a)? (Hint: Saving can be a negative number
if the consumer needs to borrow in order to maintain a certain level of consumption.)
c. Suppose there are n people born each period. What is total saving in the economy?
(Hint: Add up the saving of each age group. Remember that some age groups may have
negative savings.) Explain.
d. What is total financial wealth in the economy? (Hint: Compute the financial wealth of
people in the beginning of the first period of life, the beginning of the second period,
and the beginning of the third period. Add the three numbers. Remember that people
can be in debt, so financial wealth can be negative.)
Suppose now that borrowing restrictions do not allow young consumers to borrow. If we call the
sum of income and total financial wealth cash on hand, then the borrowing restrictions means
that consumers cannot consume more than their cash on hand. In each age group, consumers
compute their total wealth and then determine their desired level of consumption as the highest
level that allows their consumption to be equal in all three periods. However, if at any time,
desired consumption exceeds cash on hand, then consumers are constrained to consume exactly
their cash on hand.
e. Calculate consumption in each period of life. Compare this answer to your answer to
part (a), and explain any differences.
f.
Calculate the total saving for the economy. Compare this answer to your answer to part
(c), and explain any differences.
g. Derive total financial wealth for the economy. Compare this answer to part (d), and
explain any differences.
h. Consider the following statement: Financial liberalization may be good for individual
consumers, but it is bad for overall capital accumulations. Discuss.

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Econ 3024 Assignment 1 (Final Version)

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Spring Semester, 2016

Due Date: 4:30pm Tuesday, 1st March, 2016.

Econ 3024 Assignment 1

Spring Semester, 2016

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