Paul decides how to consume in the two periods of his life based on the intertem
ID: 1199475 • Letter: P
Question
Paul decides how to consume in the two periods of his life based on the intertemporal consumption model. Assume that Paul doesn’t face any borrowing constraints.
a. If MRS = C2/(3C1), Y1 = 64, Y2 = 208, r = 4%, will Paul be borrowing or saving in the first period?
b. Assume that r increases to 12%. Will Paul now be borrowing or saving in the first period?
c. Consider Ye2 = 208(1 + 0.12)/(1 + 0.04) = 224. Compute the optimal Ce1 given this new value for Ye2, MRS = C2/(3C1), Y1 = 64, and r = 4%. The difference between Ce1 and the value of C1 that you computed in point a. is the income effect. The difference between the value of C1 that you computed in point b. and Ce1 is the substitution effect. Which one of the two effects dominates? Is this what you were expecting given your results from point a. and point b.?
d. Marie also decides how to consume in the two periods of her life based on the intertemporal consumption model. However, Marie has a borrowing constraint. Use the expression for the intertemporal budget constraint to show that if Maria’s optimal choice implies that C2 < Y2, then her borrowing constraint will be binding.
e. Because of her borrowing constraint, Maria is forced to consume C1 Y1. Is it possible that this consumption combination lies on a higher indifference curve than her optimal choice in the absence of a borrowing constraint? Explain.
I have an exam tomorrow, and I don't understand how to do this practice problem.
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Explanation / Answer
Paul decides how to consume in the two periods of his life based on the intertem