Suppose an individual has a fixed amount of wealth to allocate between consumption in two periods (c₁ and c₂) .Any funds not spent in period 1 will earn interest (at the rate r) which will increase purchasing power in period 2.
Consider four possible reactions to an increase in r:
I.c₁ increases.
II.c₁ decreases.
III.c₂ increases.
IV.c₂ decreases.
Which of these is consistent with the hypothesis that both c₁ and c₂ are normal goods?

Question

Quizplus · Accepted Answer

If both c₁ and c₂ are normal goods, then an increase in interest rates will increase the opportunity cost of current consumption, leading to an increase in savings and therefore an increase in funds available for future consumption. This leads to an increase in c₂ which is consistent with reaction III. However, it will also increase the present value of future income, which will increase c₁. Therefore, I is also consistent with the hypothesis. Since an increase in r is associated with a decrease in the present value of current consumption, reaction II is not consistent with the hypothesis. Finally, since both goods are normal, a decrease in r will decrease c₂ (IV). Therefore, the best choice is E.

Suppose an Individual Has a Fixed Amount of Wealth to Allocate