Question

Borrowing Constraint in the Two-Period Model life, your ability to borrow is not In real usuallv based on vour lifetime income but rather on vour current annual income. So we will consider a partial equilibrium framework of an individual who faces a borrowing constraint. That is, the household cannot borrow more than a pre-specified amount. For simplicity, we will assume that the household cannot borrow at all; thus The rest of the problem remains identical as the household wishes to maximize In(c) + β ln(9) max, (c1,c2,bi) subject to (a) For now assume the household DOES NOT face the borrowing constraint, write down the (b) Without the borrowing constraint, what is the natural borrowing limit? That is, what is (c) What is the effect of an increase in the current income yi , on current consumption, cı? (d) From this point forward, the household IS facing the borrowing constraint as specified solutions for ci, c2 and bı to the problem above. the largest value ci can get, and what is the largest absolute value bi can be negatively. Specifically find jr1 above, that is that b1-0. Draw the lifetime budget constraint in the c1, c2 -space taking into account this borrowing constraint (e) Under what condition does the borrowing constraint become binding? (Eg: what does it imply about their income stream)

Answer 1