Question

a) what is the market rate of interest? (Hint: The new market interest rate line EF is parallel to AH.)

The following figure depicts the financial situation of Jane Fawn. In period O, her labour income and current consumption are $50; later, in period 1, her labour income and consumption will be $44. She has an opportunity to make the investment represented by point D. By borrowing and lending, she will be able to reach any point along the line FDE. Period 1 ($) - (1+) HK B VA VE Period 0 ($) 50 70 85

b) What is the NPV at point D?

c) c. If Jane wishes to consume the same quantity in each period, how much should she consume in period 0? Assume the investment represented by point D is undertaken. (Round the final answer to 2 decimal places.)

Answer 1

a) -(1+r) = slope of FE

-(1+r) = 44-0/50-70

-(1+r) = -2.2

2.2-1=r

1.2=r

market rate of interest is 1.2

b) NPV at point D = $85-$70 = $15

c) If her wealth is $85, C0 is $50, 1+r is 2.2, then she can consume

C0+ C/1+r =wealth

50+C/2.2 =85

C/2.2 =85-50

C/2.2= 35

C=35*2.2

C= $77