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intertemporal utility maximisation

Economics Asked by skukkzky on January 4, 2021

Adam’s consumption period 1 and 2 are denoted by $c_1$ and $c_2$ respectively. His utility function is $U(c_1,c_2)=4c_1^{0.5} + c_2$
Ben earns an income of $3 in period 1 and $3 in period 2, regardless of the level of inflation.
a. Suppose there is no inflation and the interest rate is 5%. How much will Ben consume in each period?
b. Now suppose that inflation rate rise to 100%. How much will Adam consume in each period now?

For part a, I took $c_2= -1.05c_1 + 6.15$ as the budget line and equated it to
MRS of his utility function. I managed to obtain $c_1 = 3.63$ and $c_2= 2.341$.

However, I am unsure of how to do part b as I obtain a negative answer for $c_2$ after doing the same steps as part a. The only differenece was that I took into account inflation for part b.

One Answer

The purpose of part b is probably to illustrate what happens during hyper inflation: people spend there money immediately while they get anything for them.

Note that there is probably an implicit constraint that $c_2$ cannot be lower than 0, so the answer would be $c_1 = $6, c_0 = $0$.

Answered by Klas Lindbäck on January 4, 2021

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