We return to the planet Mungo. On Mungo, macroeconomists and bankers are jolly, clever creatures, and there are two kinds of money, red money and blue money. Recall that to buy something in Mungo you have to pay for it twice, once with blue money and once with red money. Everything has a blue-money price and a red-money price, and nobody is ever allowed to trade one kind of money for the other. There is a bluemoney bank where you can borrow and lend blue money at a 50% annual interest rate. There is a red-money bank where you can borrow and lend red money at a 25% annual interest rate. A Mungoan named Jane consumes only one commodity, ambrosia, but it must decide how to allocate its consumption between this year and next year. Jane’s income this year is 100 blue currency units and no red currency units. Next year, its income will be 100 red currency units and no blue currency units. The blue currency price of ambrosia is one b.c.u. per flagon this year and will be two b.c.u.’s per flagon next year. The red currency price of ambrosia is one r.c.u. per flagon this year and will be the same next year.
(a) If Jane spent all of its blue income in the first period, it would be enough to pay the blue price for _______ flagons of ambrosia. If Jane saved all of this year’s blue income at the blue-money bank, it would have _______ b.c.u.’s next year. This would give it enough blue currency to pay the blue price for _______ flagons of ambrosia. On the graph below, draw Jane’s blue budget line, depicting all of those combinations of current and next period’s consumption that it has enough blue income to buy.
(b) If Jane planned to spend no red income in the next period and to borrow as much red currency as it can pay back with interest with next period’s red income, how much red currency could it borrow?
(c) The (exact) real rate of interest on blue money is _______. The real rate of interest on red money is _______.
(d) On the axes below, draw Jane’s blue budget line and its red budget line. Shade in all of those combinations of current and future ambrosia consumption that Jane can afford given that it has to pay with both currencies.
(e) It turns out that Jane finds it optimal to operate on its blue budget line and beneath its red budget line. Find such a point on your graph and mark it with a C.
(f ) On the following graph, show what happens to Jane’s original budget set if the blue interest rate rises and the red interest rate does not change. On your graph, shade in the part of the new budget line where Jane’s new demand could possibly be. (Hint: Apply the principle of revealed preference. Think about what bundles were available but rejected when Jane chose to consume at C before the change in blue interest rates.)