SOLUTION: UCB Intermediate Macroeconomic Wealth & Income Inequality Question

Econ 302 – Intermediate Macroeconomics
Spring 2021
Assignment 3 – Part 2 only
Z. Janko
DUE: Saturday March 6th by 10pm.
SUBMISSION: upload your assignment on iLearn by 10pm. Upload a PDF file.
Worth: 10 points
REMARK: Part 2 is worth 10 points; Part 1 is on MyEconLab and is worth 15 points.
Please note that not completing the homework will very negatively affect your grade in the course.
HW INSTRUCTIONS: Answers to question 2 MUST BE TYPED. Please submit a PDF or original
photos of your work (do not submit a word file, or pages, or a zip file, etc.).
1. [5 points] Suppose that MPKf = 1000 – 10Kf, unit price of capital (pk) = 1000, depreciation = 10%,
and the real interest rate = 2%. Use this information to answer the questions below.
a. Calculate the user costs. (use decimals in your calculations: so use d=0.1 and r=0.02)
b. What is desired future capital stock (Kf*) equal to? Calculate it (show work).
c. If Kt (current capital) = 60, what is Investment equal to? Calculate it (show work).
d. Suppose that Af rises so that the new MPKf is equal to 1010 – 10Kf. Calculate the new values of
Kf* and Investment given this shock. Did these rise or fall? Just state.
e. Continue with d. Show the impact of a rise in Af on Kf using a diagram (a diagram that has Kf on
the x-axis; as in figure 4.3 in the text). Clearly illustrate the impact. Show your answer on a diagram.
f. Continue with d. Now DISCUSS (intuitively) the impact of the rise in MPKf. Make sure to
provide economic reasoning for the changes in Kf and Investment.
2. [5 points] Read the article posted on iLearn titled: “Education, Income, and Wealth” and then answer
the questions below:
a. What does the article state about income inequality and wealth inequality? Discuss both and support
your discussion with the evidence (data/stats presented in article).
b. Define savings and wealth (article provides both). Then discuss what is necessary to turn income
into wealth.
c. What is “The life cycle theory of consumption and savings”? Discuss and draw figure 3 (make sure
to completely label the figure). You can refer to the figure in your discussion. [draw your own
figure – do not take a photo of the figure and then cut and paste it]
d. What is the relationship between education and income? Discuss and support your discussion with
the evidence (data/stats presented – see table on page 3).
e. Describe how the following 3 financial habits contribute to well educated families’ ability to build
wealth over time: liquid assets, diversification, and low debt to relative assets.
f. Explain why the relationship between education and income might not be as simple as it first
appears (see box on top of page 4).
PAGE ONE Economics
Education, Income, and Wealth
Scott A. Wolla, Ph.D., Senior Economic Education Specialist
Jessica Sullivan, Economic Education Intern
Asset: A resource with economic value that an
individual, corporation, or country owns with
the expectation that it will provide future
“By some estimates, income and wealth are near their highest levels
in the past hundred years, much higher than the average during that
time span and probably higher than for much of American history
before then.”
—Janet Yellen, Federal Reserve Chair1
Capital gains: A profit from the sale of financial
Compound interest: Interest computed on the
sum of the original principal and accrued
Credit score: A number based on information
in a credit report used to indicate a person’s
credit risk.
Delinquency rate: The number of loans that
have delinquent payments relative to the
total number of loans.
Financial asset: A contract that states the conditions under which one party (a person or
institution) promises to pay another party
cash at some point in the future.
Financial investment: Placing money in a savings account or in any number of financial
assets, such as stocks, bonds, or mutual funds,
with the intention of making a financial gain.
Americans have among the highest living standards in the world and have
enjoyed rising living standards for decades. Median household income in
the United States in 2015 was $56,516, up from $49,276 in 2010.2 However,
gains in household income have not been evenly distributed across all
income groups. Income inequality has been increasing in the United States
since the 1970s, peaking in 20133 (Figure 1). A 2015 Gallup poll found that
63 percent of Americans feel that the distribution of U.S. money and wealth
is unfair.4 While many factors contribute to income and wealth inequality,
the role of education is a key piece of the puzzle.
Figure 1
U.S. Income Inequality a Rising Trend
Income Gini Ratio for Households by Race of Householder, All Races
Financial literacy: Having knowledge of financial matters and applying that knowledge to
one’s life.
Human capital: The knowledge and skills that
people obtain through education, experience, and training.
Income: The payment people receive for providing resources in the marketplace.
Payday loan: A small, short-term loan that is
intended to cover a borrower’s expenses until
his or her next payday. May also be called a
paycheck advance or a payday advance.
Transaction costs: The costs associated with
buying or selling a good, service, or financial
Source: US. Bureau of the Census
NOTE: The Gini coefficient (also known as the Gini ratio or index) is a common
measure of income inequality within a nation. It gauges income inequality on
a scale from 0 to 1: The higher the number, the higher the level of inequality.
The lowest U.S. value was 0.386 in 1968, and the highest value was 0.482 in
2013. In 2015 the, Gini coefficient was 0.479.
SOURCE: FRED®, Federal Reserve Bank of St. Louis. Accessed November 22,
January 2017
Federal Reserve Bank of St. Louis |
PAGE ONE Economics®
Federal Reserve Bank of St. Louis |
Figure 3
A Model of Saving and Spending: The Life Cycle Theory of
Consumption and Saving
Figure 2
U.S. Personal Saving Rate Over 50 Years
Personal Saving Rate
Income, Consumption
Paying Debt and Saving
During Peak Earning Years
Saved Income
During Retirement
Borrowing for
College, Buying
a Home, etc.
Source: US. Bureau of Economic Analysis
NOTE: The horizontal line indicates the average saving rate over the period.
SOURCE: FRED®, Federal Reserve Bank of St. Louis. Accessed November 22,
The Basics
When people earn income, they use that income to do
three things: pay taxes, buy goods and services (consume),
and save. Saving is not spending on current consumption
or taxes and involves giving up some current consump­
tion for future consumption. The accumulation of money
set aside for future spending and consumption is known
as savings. Americans don’t save as much as those in
other industrialized nations. The U.S. personal saving
rate has dropped substantially over the past 50 years
(Figure 2). As of September 2016, the U.S. personal saving
rate was 5.7 percent, whereas it has historically averaged
8.4 percent (since 1959).5 By comparison, German house­
holds saved 16.7 percent, on average, in 2015.6
Saving is an essential component of building wealth.
Wealth, also called net worth, is the total value of a per­
son’s assets, such as liquid assets (cash or something you
can easily turn into cash), real estate, businesses, and
cars, minus any liabilities (money owed; debt). Saving to
build wealth is an important part of financial planning.
And debt is not necessarily a bad thing. Because income
tends to start low at younger ages, borrowing (taking on
debt) allows people to have things now and pay for them
over time. In economic terms, this is called smoothing
consumption. Income then tends to increase in middle
age and decrease when people retire. Economists often
use the life cycle theory of consumption and saving to
explain this phenomenon. As shown in the model (Fig­
ure 3), people tend to borrow to purchase homes, cars,
or an education when they are young, pay down debt
and save a portion of their income during their peak
working and earning years, and finally spend their saved
money during retirement. Within this pattern of planned
borrowing and saving, the hump-shaped pattern of
income (the curved line) allows for smooth consumption
(the horizontal line) across the lifecycle. Thus, saving—
to build wealth—is essential for a higher quality of life
during retirement.
Two similar terms must be differentiated here: Income is
the payment people receive for providing resources in
the marketplace. For example, people often receive pay­
checks twice a month. You may have heard people dis­
cuss the flow of income. Saving involves setting some of
the flow of income aside to increase wealth. Wealth is the
accumulation—or stock—of saved money. Notice that
turning the flow of income into a stock of wealth requires
saving money. There are several options for saving,
including saving in a savings accounts or saving through
the purchase of financial assets, which is called financial investment. People invest in financial assets with
the aim of “making money”—they hope to earn interest,
dividends, profits, and/or capital gains in the future.
Education and Income
The relationship between education and income is
strong. Education is often referred to as an investment
in human capital. People invest in human capital for
similar reasons people invest in financial assets, including
to make money. In general, those with more education
PAGE ONE Economics®
Federal Reserve Bank of St. Louis |
Family Financial Outcomes Based on Education
Percentage of
Median income
Median wealth
(family wealth)
No high school diploma
1 in 110
High school diploma
1 in 18
Two- or four-year degree
1 in 4.6
Advanced degree
1 in 2.6
NOTE: *Based on the education level of a family headed by someone 40 years of age or older. **This ratio shows how much wealth each group has per dollar
of income. For example, the ratio for families without a high school degree was 1.43, which means that, on average, for every $1 of income there was $1.43 of
wealth. The ratio is a measure of how efficient people are at turning income into wealth.
SOURCE: Boshara, Ray; Emmons, William R. and Noeth, Bryan. “The Demographics of Wealth: How Age, Education and Race Separate Thrivers from Strugglers in
Today’s Economy.” Essay No. 2: Education and Wealth, Federal Reserve Bank of St. Louis, May 2015, pp. 4, 5, 9, and 13;
Education and Wealth
The relationship between education and wealth is also
strong. Of course, earning a higher income makes saving
easier, and saving is necessary to build wealth. Those
with lower incomes have a flatter (non-humped) income
pattern, which makes saving and paying down debt
more difficult. But those with more education also tend
to make financial decisions that contribute to building
wealth.8 It is important to realize, however, that anyone
can follow the financial behaviors that well-educated
families tend to practice, such as these:
1) Have some liquid assets. Liquid assets can help
relieve financial distress during a difficult time with­
out having to sell assets or accumulate debt. Liquid
assets include savings accounts, stocks, and bonds.
2) Diversify. To diversify means to invest in various
financial instruments to reduce risk. In addition to
tangible assets such as houses and cars, those with
higher levels of education also tend to hold a great­
er share of their savings in stocks, bonds, and busi­
nesses, which tend to provide higher returns (but
also more risk of loss).
Figure 4
Unemployment Declines as Education Increases
Unemployment Rate: Less than a High School Diploma, 25 years and over
Civilian Unemployment Rate
Unemployment Rate: College Graduates: Bachelor’s Degree and Higher, 25 years and over
earn higher incomes (see the table). The higher income
that results from a college degree is sometimes referred
to as the “college wage premium.” Research shows that
this premium has grown over time.7 In addition, in gen­
eral, the more skills people have, the more employable
they are. As a result, workers with more education have
a lower average unemployment rate than those with
less education (Figure 4).
NOTE: In November 2016, the overall U.S. unemployment rate was 4.6 percent,
but level of education matters. The unemployment rate for college graduates
was 2.3 percent, while that for those with less than a high school diploma was
7.9 percent.
SOURCE: FRED®, Federal Reserve Bank of St. Louis. Accessed December 21,
3) Keep debt low relative to assets. Those with low
debt relative to assets pay lower interest rates. Those
with high debt relative to assets pay higher interest
rates, which can make it difficult to save. And, over
longer periods, both savings and debt are suscepti­
ble to the effects of compound interest—which
means that savings (or debt) can grow at exponen­
tial rates over time.9
It is important to realize, however, that the relationship
among education, income, and wealth is more compli­
cated than simply more education yielding a higher
income and more wealth. Factors such as natural ability
PAGE ONE Economics®
Federal Reserve Bank of St. Louis |
Correlation Is Not Causation
The relationship among education, income, and wealth seems to be fairly strong. Economists, how­
ever, are not ready to say that education alone is the cause of higher income (and wealth). In fact, you
might have heard the phrase, “correlation does not imply causation.” What does this mean? Well, just
because two things seem related does not mean that one causes the other. For example, consider
ice cream sales. They tend to increase when the rate of sunburn also increases. Does increased ice
cream consumption, then, cause an increase in the sunburn rate? Not likely. In fact, a third factor
strongly influences both—the weather. Demand for ice cream increases during the hot summer
months, when more people tend to be outdoors and thus more likely to get a sunburn.
Likewise, while at least some of the college wage premium is due to the knowledge and skills acquired
through education, other factors, such as the following, are surely at play:
• Natural ability: Those with high intellectual ability are more likely to complete college, and that
ability contributes to success in the job market as well.
• Assortive mating (“like marries like”): Highly educated people tend to marry other highly educated
people—which can double the wage premium and increase household income.
• Inheritance: People with more education are more likely to have parents with accumulated wealth
and, thus, are more likely to receive an inheritance.
• Better health and longer lifespans: People with more education tend to be healthier, which
enables them to work longer (increasing lifetime earnings) and live longer (collecting more lifetime
benefits from Social Security and pensions).1
Boshara, Ray; Emmons, William R. and Noeth, Bryan. “The Demographics of Wealth: How Age, Education and Race
Separate Thrivers from Strugglers in Today’s Economy.” Essay No. 2: Education and Wealth, May 2015, p. 7;
and family background also impact both income and
wealth and are not caused by having more education
(see the boxed insert).
The Role of Financial Literacy
Research shows that up to half of wealth inequality may
be caused by differences in financial literacy.10 That is,
many people do not have the skills or ability to manage
their money effectively. As a result, they are more likely
to use costly home loan (mortgage) products,11 pay higher
transaction costs and fees, and use high-cost borrow­
ing options.12 High-cost borrowing includes the use of
payday loans and businesses such as pawn shops and
rent-to-own stores.13 Currently only 20 states require
high school students to take a course in economics and
only 17 states require a course in personal finance.14
Research has shown, however, that such education makes
a difference: Students in states with financial education
requirements have lower loan delinquency rates and
higher credit scores relative to students in states with­
out financial education requirements.15
Income and wealth inequality have been on the rise in
the United States for decades. Research indicates that
the level of education is strongly related to both income
and wealth. Households with higher levels of education
tend to have more liquid assets to withstand financial
storms, diversify their savings (investments), and main­
tain low levels of debt relative to assets. These financial
behaviors are effective strategies for building income
into wealth. Because much of wealth building can be
tied to financial decisionmaking, it is likely that financial
literacy can play a key role in reducing wealth inequality
over time. n
PAGE ONE Economics®
Federal Reserve Bank of St. Louis |
Yellen, Janet L. “Perspectives on Inequality and Opportunity from the Survey of
Consumer Finances.” Board of Governors of the Federal Reserve System, 2014;
Boshara, Ray; Emmons, William R. and Noeth, Bryan. “The Demographics of
Wealth: How Age, Education and Race Separate Thrivers from Strugglers in
Today’s Economy.” Essay No. 2: Education and Wealth, May 2015;
U.S. Bureau of the Census. Median Household Income in the United States
[MEHOINUSA646N], retrieved from FRED, Federal Reserve Bank of St. Louis,
November 22, 2016;
Federal Reserve Bank of St. Louis. “How Has Income Changed over the Years?”
On The Economy (blog); June 30, 2016;
Newport, Frank. “Americans Continue to Say U.S. Wealth Distribution Is Unfair.”
May 4, 2015; Gallup;
U.S. Bureau of Economic Analysis, Personal Saving Rate [PSAVERT], retrieved
from FRED®, Federal Reserve Bank of St. Louis, November 22, 2016;
Beisemann, Leonie. “A Dash of Data: Spotlight on German Households.” OECD
Insights, February 11, 2016;
Valletta, Rob. “Higher Education, Wages, and Polarization.” Federal Reserve Bank
of San Francisco Economic Letter. January 12, 2015;
Lusardi, Annamaria; Michaud, Pierre-Carl and Mitchell, Olivia S. “Optimal
Financial K …
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