Explain how much will you be able to spend next year

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Reference no: EM1363472

1. Suppose you have $1000 today and expect to receive another $1000 one year from today. Your savings account pays an annual interest rate of 25%, and your bank is willing to lend you money at that same interest rate.

(a) Suppose that you save all of your money to spend next year. How much will you be able to spend next year? How much will you be able to spend this year?

(b) Suppose you borrow $800 today and spend $1800 today. How much will you be able to spend next year?

(c) Draw your budget constraint between "spending today" and "spending next year." What is its slope? How does the the slope reflect the relative prices of spending today in terms of spending next year?

(d) How would your budget line shift in each of the following circumstances? You find $400 that you'd forgotten was in your desk drawer.
Your boss informs you that you will receive a bonus of $500 next year. The interest rate rises to 50%.

(e) Returning to the assumption that you have $1000 today and expect to receive another $1000 one year from today. Suppose you choose neither to lend nor to borrow at interest rate 25%. Now suppose the interest rate rises to 50%. Do you increase or decrease your
current spending? Do you increase or decrease your future spending? Are you better off or worse off than before?

(f) In part (e), decompose the change in your consumption into a substitution effect followed by an income effect. Can you determine the direction of the substitution effect? Can you determine the direction of the income effect?

Reference no: EM1363472

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