Question

1. Explain how the intertemporal budget constraint and indifference curves are used to derive a consumer’s optimal choice of current and future consumption.

2. Explain how the desired levels of capital and investment are affected by changes in the expected marginal product of capital, the user cost of capital, and taxes.

Answer 1

1. Intertemporal budget constraint is a constraint faced by a decision maker who is making choices for both the present and the future. In its general form it says that the present value of current and future cash outflows cannot exceed the present value of currently available funds and future cash inflows (income available for spending in present and future)

2.Desired capital stock-It is the amount of capital which allows the firm to earn the highest profit.

Expected marginal product of capital : If the expected marginal productis higher,the the desired capital stock would also be more as it will lead to more productivity that would ultimately lead to more demand for capital.

Cost of capital : More user cost will lead to less profit,

Tax rate : Less tax rate would lead to higher stock of capital since lower tax rate would lead to rise in profit of the company and more tax rate would lower the desired stock of capital,since high tax will drag down the company profit.