Question: Suppose your expected incomes in years 1 and 2 are $60,000 and $70,000 respectively. You have 40,000 in cash in year 0. Market interest rates for one-year loans are 8% in year 0 and 14% in year 1.
1. If your minimum consumption level today is 20,000 and it is growing at 10% for the next two years, what will be your consumption potential in years 1 and 2? Consumption potential is defined as the amount you can consume in a given year if your consumption in the other two periods is at (respective) minimal levels.
2. Suppose a bank offers an account that pays a fixed yearly rate of interest but allows no withdrawal until the end of the second year. If your objective is to maximize your consumption potential in year 2, what is the lowest rate r you would be willing to accept from the bank?
3. Assume the interest rate that a bank offers you for two year loans is above the minimum rate you computed in (b). You still have access to one year loans as in (a). Keep the assumption that you want to maximize your consumption potential in year 2. What do you do with the unconsumed part of your year 1 income?