A two period consumption smoothing practice question econ 304 fall 2011

2. a) The Comic below motivated this question. Suppose we have Dagwood, who has a
current income of $120K and expected future income of $50K. He has $60K in current
wealth (i.e., a = $60K), but this is before he opens that #$@% envelope. He has zero
expected future wealth.

Dagwoods behavior is consistent with the life-cycle theory of consumption. For one, he
perfectly smoothes consumption and
two, he is in his peak earning years
and thus, he is saving now so that he
can maintain his current level of
consumption in the future. Given that
Dagwood faces a real interest rate of
0.10, calculate his optimal level of
consumption (C*) given his perfect
consumption smoothing preferences.
Then draw a picture (our two period
consumption model) depicting these
current conditions (this is before he
opens the envelope) being sure to
label everything! Label initial point
as point A.

Now Dagwood cant help himself and

opens up that envelope and ouch he
says, his a or current wealth has lost
one third (33%) of its value and thus
falls from $60K to $40K. There has been no change yf, y, or r. Recalculate Dagwoods
new optimal bundle (the new C*) and label as point B. Naturally, Dagwood is worse
off due to this development as he falls on a lower indifference curve.
 2 b) Dagwoods neighbor, Homer Simpson, does not abide by the
life cycle theory of consumption. Homer has a lets live life like
its 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). Homers current income equals $120K and his future expected
income = $140K. He has no wealth (neither current nor expected)
since he lives like today is his last! Solve for Homers optimal consumption basket
today (C*) and his optimal consumption basket next period (Cf*). Please provide a
completely labeled graph depicting these results.

Now Homer, of course, is not affected by the crashing market since he has no envelope to
open!

THE FED TO THE RESCUE!

In steps Ben Bernanke and the Fed and they conduct massive amounts of open market
purchases and some how get the real rate of interest all the way down to .
03 (3% but use decimal form of course). Recalculate the optimal
bundles for both Dagwood and Homer and show all these changes on
your two (existing) diagrams being sure to label everything. Who is
better off and who is worse off after the interest rate change and why?
Be sure to include a discussion of the income and substitution effects
for both consumers.

Finally, given the big picture, are there any winners here? That is, consider the
welfare changes (as measured by C*) for Dagwood and Homer given the crash in the
market and the change in r. Is there a Moral Hazard problem? Why or why not?