Draw the budget constraint and optimal

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Reference no: EM131084722

Omar will earn $20,000 this year and $50,000 next year. He can borrow and lend at an interest rate of 25%. He decides to borrow $15,000 this year. a. Draw Omar’s budget constraint for consumption spending this year and next, label the amounts at the endpoints, and identify his endowment and his chosen consumption bundle. Sketch an indifference curve consistent with his chosen bundle. How much will he spend on consumption this year? How much next year? b. Now Omar has learned that his income next year will only be $25,000 (this year’s will still be $20,000). In your diagram from (a), show a possible outcome for how this change affects his budget constraint, assuming the permanent income hypothesis holds. How will this change affect Omar’s consumption in each period and the amount he borrows? (Just provide the direction of the effects, not numbers.) Explain carefully, using the diagram if you like. c. Now draw the budget constraint and consumption choice from part (a) again on a new diagram. Suppose the interest rate doubles, and Omar reduces his borrowing to $5,000. Draw the budget constraint and optimal choice before and after the change in interest rate. Has Omar’s planned period 2 consumption increased or decreased?

Reference no: EM131084722

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