Suppose that you are currently a college senior. You are currently working a part-time job that pays $2,000 per year (call it Y1), but you expect to earn $20,000 next year (call it Y2), after you graduate. Assume that there is no inflation and that the interest rate is 10% per year.
a) You want to smooth consumption such that consumption this year equals consumption next year (that is C1=C2.) Solve for consumption this year and next year. What is your saving (S)? [Hint: in this case S will be negative; you borrow against your future income. You are dis-saving.]
b) Suppose that your current income (Y1) doubles to $4,000 per year. What happens to your current consumption? What happens to your saving? [numbers please]
c) Suppose that expected income (Y2) doubles to $40,000 per year. What happens to your current consumption? What happens to your saving? [numbers please]
d) Go back to the initial incomes. Suppose that the interest rate suddenly increased to 15%. Solve for consumption this year and next year.