Reference no: EM131242512
Alan has only two years in his life. He will earn $20,000 in year one and $11,000 in year two. Assume Alan saves $5000 in year 1 and the interest rate = 10%.
a) How much (in dollars) does Alan consume in year 1?
b) How much interest does Alan receive on his savings? How much does Alan receive in savings in year 2 (savings + interest)? How much does Alan consume in year 2? Include all this on the graph.
c) Instead, if Alan saves $20,000 in year 1, then how much will he consume in year 2? How much will he spend in year 1? Instead, what is the most Alan can borrow against his future earnings? Now how much would he consume in year 1 if he borrowed all he could? How much would he have to spend in year 2?
d) Graph the budget line, and include the endpoints. Since, by assumption, the consumption point in b is Alan's best choice, draw in his corresponding indifference curve for the consumption point in b.
e) Congress often talks of reducing taxes on savings (and hence, increase the real return) with plans like IRAs etc., to increase savings. Show, using the concepts of income and substitution effects, that higher interest rate increases consumption in year 2 but may either increase or reduce the amount saved in year 1. (Hint: increase the interest rate to change the budget lines.) Graph the income and substitution effects.
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