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Question 2: Consumption Decisions (30 Marks) Suppose a person's life is divided into two main blocks,...

Question 2: Consumption Decisions
Suppose a person's life is divided into two main blocks, periods 1 and 2. The consumer does not desire
to perfectly smooth consumption over the two periods. In particular, preferences are such that c2 = 0:5 c1.
Income in the two periods is equal to y1 = 500 and y2 = 1000, and income taxes are proportional 1 = 50%
and 2 = 50%. The real interest rate is r = 0%.
(a) What is the present value of lifetime resources (PVLR)? What is the highest feasible consumption in
the current period? What is the highest feasible consumption in the future period?
(b) Find the optimal consumption in each period (c1
; c2
) and the amount of saving/borrowing. Comment
on your findings.
(c) What happens to the consumption and saving choices if the real interest rate is r = 100% and there
are no taxes (1 = 2 = 0%)? Comment on your findings.

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