Question

[For Q2-Q31 Under the two-period Fisher model of consumption, suppose that Jamil earns nothing in the first period and $600 in the second period. The interest rate is 0.2 (i.e., 20%). Jamil decides to consume $300 in the first period. Q2. How much does Jamil consume in the second period? Answer: a) $240 b) S300 c) $360 d) $600 Q3. Suppose that the interest rate falls to 0.1 (ie, 10%). Then the substitution effect the first the first period consumption. period consumption while the income effect Answer a) increases; increases b) increases; decreases c) decreases; increases d) decreases; decreases

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Answer 1

Under two-period Fisher model of consumption Intertemporal Budget constraint- C_1 + C_2/1 + r present value of life time consumption = Y_1 + Y_2/1 + r present value of lifetime income where Y_1 = present income, C_1 = current income Y_2 = future income C_2 = future income r = rate of interest 300 + C_2/1 + 0.2 = 0 + 600 C_2/1.2 = 600 - 300 C_2 = 300 (1.2) = $ 360 (Ans) If s falls to 0.1 then the opportunity cost of current consumption falls which increases current consumption According to substitution effect According to income effect, if r decreases than Jamil becomes off & his consumption decreases in both the period (b) increases, decreases