Assume a consumer living for two periods, Period 1 and Period 2 earns income Y1

Question

Assume a consumer living for two periods, Period 1 and Period 2 earns income Y1 and Y2 in each period. What happens to his consumption path if his/her subjective discount factor (p) is lower than interest rate (r) Select one: A. The consumer consumes less in period 1 to increase his consumption path higher than his income in period 2 B. The consumer consumes all his income in period 1 and saved nothing for period 2 C. The consumer is indifferent, hence consumes all his respective incomes in period 1 and 2 D. The consumer increases his consumption in period 1 Previous page

Explanation / Answer

A is correct.

Lower the discount factor higher is the present value of future income.

Interest rate is income earned on savings.

So when interest rate is higher than discount factor, it implies your future income is higher than present income. This encourages you to save more and consume less in period 1.

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