Suppose that y 100 income today y 150 income tomorrow r 10

Suppose that

y =100 (income today)

y\' = 150 (income tomorrow)

r = 10% (interest rate on bonds)

t = 10 (taxes today)

t\' = 10 (taxes tomorrow)

The consumer is choosing optimally (c,c\'), and her preferences are the same as the ones described in Lecture 8:

Consumer Preferences from Lecture 8:

- We will focus on bundles (c,c\') (ignore leisure for now)
- Both present and future consumption are normal goods
- Consumer prefers more to less (for both c and c\')
- Consumer likes combinations of (c,c\')
- Idea: Suppose your income is $1000 today and $0 tomorrow.
Is it better to eat for $1000 today and starve tomorrow, or consume for $600 today and $400 tomorrow?
- Our consumer always prefers the latter scenario to the former

Suppose that y\' all of sudden becomes 200. How does s change?

s will have a positive change: if the present value of income grows, I want to save some for the future

s will have a negative change: the present value of income is growing, so the consumer wants to increase consumption both today, and tomorrow. Since y did not change, the only way to increase consumption today is to diminish s

s will have a positive change: if the value of income grows tomorrow, I want to save some more money, so that tomorrow I will consume a lot

Solution

b is correct

Since consumers prefer to smooth their consumption during their lifetime. When income in future increases consumer is likely to save less today as income in future will be higher. So to smooth consumption over both periods, saving is reduced today.