# Suppose you expect to earn \$10 this year and \$10 next year. Each dollar you earn this year can be be either spent, or saved at an interest rate of…

Suppose you expect to earn \$10 this year and \$10 next year. Each dollar you earn this year can be be either spent, or saved at an interest rate of 10%. If you want to spend more than \$10 this year, you can borrow money at 10% interest and repay it next year. Next year, you plan to pay o

1. Draw your budget line between “dollars spent this year” and “dollars spent next year”.
2. Suppose the government imposes a 50% income tax on all your earnings this year and next year (not including your interest earnings). Draw your new budget line.
3. Suppose the government imposes a 50% sales tax on everything you buy this year and next year. Draw your new budget line.
4. Suppose the government imposes a 50% income tax on all your earnings this year and next year, including your interest earnings. Draw your new budget line.
5. True or False: If interest earnings are not subject to income tax, then an income tax and a sales tax will lead you to spend exactly the same amount both this year and next year.

Suppose you allocate all your wealth to “housing” and “savings”. Housing costs \$40 per square foot. You have \$100,000 in wealth and have elected to build a 1000 square foot house.

1. Draw your budget line between housing (on the horizontal axis) and savings (on the vertical). Draw the indifference curve you are on and illustrate your optimal consumption.
2. Now suppose the price of housing falls to \$30 per square foot. Draw your new budget line. (Hint: You can keep your existing house if you want to.)
3. True or False: The fall in housing prices makes you happier.
4. Assume that housing is an inferior good and illustrate the substitution and income effects from a fall in housing prices.
5. True or False: If housing is an inferior good, then in this problem the substitution effect must be larger than the income effect.