In the two-period model, suppose a household's income in the first period is $40,000, income in the second period is $50,000, and the real interest rate is 25 percent.A sudden shock leads to an increase in the household's income in the first period to $45,000 and a decrease in the household's income in the second period to $43,750.The household is _____in the new situation.
A)better off
B)worse off
C)equally well off
D)possibly better off and possibly worse off

Question

Quizplus · Accepted Answer

Initially, the household can consume $40,000 in the first period and, by saving at a 25% interest rate, can consume $50,000 + ($10,000 * 1.25) = $62,500 in the second period. After the shock, they can consume $45,000 in the first period and, by saving at a 25% interest rate, $43,750 + ($1,250 * 1.25) = $45,312.50 in the second period. However, if they choose to smooth consumption perfectly across periods, they would consume $50,000 in each period both before and after the shock, by borrowing or lending at the interest rate. Therefore, their ability to smooth consumption over the two periods remains unchanged, making them equally well off.

In the Two-Period Model, Suppose a Household's Income in the First