Question

Jane lives two periods. Her income in the current period is ?=500, her income in the future

period is yf=660 and her real wealth at the beginning of the current period is ?=100. The real interest

rate is ?=0.1 or 10%. Also, Jane wants her current consumption to be 2.5 times greater than her future

consumption.

a. Compute the present value of Jane’s lifetime resources (PVLR).

b. Determine the optimal values for Jane’s current consumption ( c ), current saving ( s ) and future

consumption ( cf ).

c. Given Jane’s chosen consumption pattern over her lifetime as determined in (b) above, suppose

the real interest rate rises. Explain what will happen to Jane’s current consumption (c) and

current saving (s) as a result of the increase in the real interest rate. Your answer should

incorporate a discussion of the income and substitution effects.

Answer 1

Present value of janes lifetime resources

=current year income+current year initial wealth

=500+100=600

when the interest rate rises the current consumption decreases and current savings increases. and jane will start using substitute products with lesser price. when the interest rate increases jane will not be able to consume normally as she consumed earlier. so instead of spending much amount she will start selecting substitute products for all the products she is using now . because when intresst rate increases her income will start reducing. when income reduces people start to save the money for future purpose so the consumption decreases and savings increases and consumption of substitute goods also increases