The consumer’s problem: Logarithmic preferences

This question appeared (verbatim) on the 2016 final exam.

Question III (40 points): The consumer’s problem in a dynamic model

Consider a two-period consumption-saving model from Chapter 9. A consumer’s income in the current
period is exogenous. The incomes in the current and in the future periods are denoted by y and y’. There
are no taxes. The consumer’s utility function is given by

U(c,c’) = lnc + β lnc’, 0< β <1,

where β denotes the discount factor.
To answer questions a) to e), assume that the credit market is perfect. The real interest rate on borrowing
and lending is denoted by r.

a) (5 points) State in details the consumer’s optimization problem.

b) (5 points) Derive and interpret the two conditions that define the optimal choice of
consumption in the current and in the future periods.
c) (5 points) Find the analytical expressions for the optimal values of consumption in both
periods, and optimal savings s.
d) (5 points) Suppose y =480, y’=500 and β=0.9. Consider the real interest rate r=0.1. What
are the optimal values of consumption in both periods? Is the consumer a lender or a
borrower? Explain.
Represent the consumer’s choice of c, c’ and s on a graph. Make sure to label the axes and
the points of the intercepts of the budget constraint with the horizontal and vertical axes.
Indicate the value of the slope of the budget constraint, the endowment point, and the point
of optimality.
e) (10 points) Keep the values y=480, y’=500 and β=0.9. Suppose the real interest rate
increases to r=0.2. Find the new optimal values of consumption. Is the consumer a lender
or a borrower? Explain.
How is the consumer’s welfare affected by the increase in the real interest rate? Compare
with the case of r=0.1. Explain your response.
Draw a new graph to illustrate the impact of a higher real interest rate on the consumer’s
choice. On this diagram, show the optimal consumption choice for the old and the new
interest rates. Comment on the relative strength of the income and substitution effects of
the real interest rate changes.
To answer questions f) and g), assume that the consumer can lend at the real interest rate r1=0.1 but can
only borrow at the real interest rate r2=0.2.

f) (5 points) Draw a graph to illustrate the set of feasible consumption allocations. Be precise about
the relevant interest rates. What are the optimal values of consumption in both periods? Is the
consumer a lender or a borrower? Explain. Illustrate the optimal choice on the graph.
g) (5 points) How is the consumer’s welfare affected by this type of credit market imperfections?
Compare with the case of perfect credit markets. Explain your response.

ECO 3152 Macroeconomic Theory III