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Name _____ ____________ last 4 PSU ID _____ Please check section that you are registered in: Section 002 - MWF 8:00 - 8:50 am: 102 Forum Building _______ Section 001 - MWF 1:25 - 2:15 pm: 101 Thomas Building ________ Fall 2014 Chuderewicz - YOU MUST HAND IN HW IN THE SECTION YOU ARE REGISTERED FOR - NO EXCEPTIONS YOU MUST USE THIS AS A TEMPLATE – THAT IS – MAKE SPACE FOR YOUR ANSWERS BY HITTING ENTER (you certainly don’t need to type this assignment)– LEAVE THE QUESTIONS AS THEY ARE – AND PLEASE STAPLE! NOTEBOOK PAPER (OR ANY PAPER) STAPLED TO THE BACK IS NOT ACCEPTABLE (GETS A ZERO). ALSO, PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME IN THE TOP RIGHT HAND CORNER OF THIS PAGE SO THAT WE …show more content…

In this particular case, the income and substitution effects work in the opposite direction.
When it comes to substitution effect on this particular case, current consumption becomes less expensive relative to future consumption when real interest rates fall. Thus, he substitutes away from future consumption toward current consumption. When it comes to income effect on this particular case, he feels poorer thus, cuts back on current and future consumption. Also, he will increase current saving.
This is because lower real interest rates reduce real income such as interest income.
Also, the future value of current resources falls as real interest falls.

2. (NEW GRADER) (30 points total) Dagwood’s neighbor, Homer Simpson, does not abide by the life cycle theory of consumption. Homer has a “let’s live life like it’s our last day” mentality and thus, he prefers to consume more today, relative to the future. In particular, Homer prefers to consume exactly twice as much today (c), relative to consumption next period (cf). Homer’s current income equals $100K and his future expected income = $100K. He has no wealth (neither current nor expected) since he lives like today is his last! Homer faces a real interest rate of 0.05. Please answer the following questions.

a) (5 points) Solve for Homer’s optimal consumption basket today (C*) and his optimal consumption basket next period (Cf*). Please provide a completely labeled graph depicting


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