Will Wisp will live for exactly two periods. His utility function is U(c₁, c₂) = c₁c₂, where c₁ is consumption in period 1 and c₂ is consumption in period 2. He will have no income in period 2. His income in period 1 is $80,000. If the interest rate rises from 10 to 12%: A) his savings will increase by 2% and his consumption in period 2 will increase. B) his savings will not change but his consumption in period 2 will increase by $800. C) his consumption in both periods will increase. D) his consumption in both periods will decrease. E) his consumption in period 1 will decrease by 12% and his consumption in period 2 will increase.

Question

Quizplus · Accepted Answer

Since Will Wisp will not have any income in period 2, he will have to save a portion of his income in period 1 to consume in period 2. With the interest rate rising, he will get a higher return on his savings. However, since he is not changing his planned life cycle consumption, his savings will remain the same. But the higher interest rate will generate an additional interest income of 2% of his savings, which is $800. Therefore, his consumption in period 2 will increase by $800.

Will Wisp Will Live for Exactly Two Periods