4) Suppose you wanted to study intertemporal food purchases. You have annual dat

Question

4) Suppose you wanted to study intertemporal food purchases. You have annual data on

food purchases. Would it be valid to assume that food in one year and food in another year

are perfect substitutes? Why or why not?

5) A consumer, who is intially a lender, remains a lender even after a decline in interest

rates. Is this consumer better o or worse o after the change in interest rates? If the

consumer becomes a borrower after the change is he better or worse off?

6)What is the present value of $100 one year from now if the interest rate is 10 percent?

What if the interest rate is 5 percent?

Explanation / Answer

4) No in case of intertemporal choices, food in present year cannot be a perfect substitute for next year.This is because there is a rate of interest attatched with future consumption .If that rate is higher they would consume more in future than at present. i.e. present consumption C1 = C2/(1+r) where C2 is the future consumption while r is the rate of interest. Clearly if this Rate of interest increases the person would consume more in future as PV of future consumption falls or future value of current consumption increases.Hence in case of intertemporal decision making present consumption and future consumption cannot be substitutes unless the interest rate reduces to 0.

5) A consumer who remains a lender even after a decline in interest rates will surely would be worse off if the interest rate falls.As in that case the future value of his current consumption would fall or the present value of his future consumption will rise so if he continues to save at present for future consumption he is bound to loose.However if he switches from being a lender to a borrower he would be better off .The lesser are the interest rates the more better it is to consume more and more at present.Thus a borrower is better off in such situation.

6)Present value of $100 one year fro now is = 100/(1+r) = 100/(1+.10) = 100/1.1 = 90.90

If the interest rate falls to 5 percent the present value would increase. PV = 100/(1+.05) = 100/1.05 = 95.24

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