Matt’s life is divided into two time periods, young and old, and his utility is a function of two “goods”: consumption when young and consumption whenever old. Consumption when young and consumption when old are both of normal goods to Matt. When he’s young, he works and earns an income. When he’s old, he no longer earns an income and his consumption is determined by how much of his income he saved when was young, and the rate of return he earned by investing those savings. Initially, Matt anticipates a return of 50% on his savings (in other words, he expects that every $1 he saves when young will allow him to spend $1.50 when old). Now suppose Matt finds out that his rate of return will actually be 100% (every dollar he saves when young will allow him to spend $2 when old). Suppose this information on the new rate of return comes while Matt is yet young and can still adjust his savings decision.
a. How will Matt’s savings modify in response to getting a 100% rate of return instead of a 50% rate of return?
Save less
Save more
Save the same amount
Not enough information to tell
b. Briefly describe how the income and substitution effects work in this situation(Hint: this descriptionshould help you answer part a!)