Assignment 1

Suchibrata Dutta
September 12, 2013
Problem 1. First we calculate rst and second derivative of each utility func-
tion. And then we calculate coecients of risk aversion separately for each of
them. For the rst utility function:
U(c) =
1

e
c
(1a)
U

(c) = e
c
(1b)
U

(c) = e
c
(1c)

(c)
U

(c)
= (1d)

(c)
U

(c)
c = c (1e)
and for the second utility function:
U(c) =
c
1
1
(2a)
U

(c) = c

(2b)
U

(c) = e
1
(2c)

(c)
U

(c)
=

c
(2d)

(c)
U

(c)
c = (2e)
Comparing equations (1d) and (2d) we see that coeceint of absolute risk
aversion is invariant to level of c for the utility function given by (1a). This is a
constant absolute risk aversion utility function. And comparing equations (1e)
and (2e) we see that coecient of relative risk aversion is invariant to level of c
for utility function given by (2a). This is a constant relative risk aversion utility
function.
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Problem 2. Let the consumption in two periods be c
1
and c
2
and income
be y
1
and y
2
respectively. Saving s in period 1 is given by s = y
1
c
1
. Then
c
2
= (1 + r)s + y
2
where r is the net interest rate. Let R = 1 + r be gross
interest rate. Substituting s from these two equations we get c
1
+
c
2
R
= y
1
+
y
2
R
.
Given agents felicity function is u(c) =
c
1
1
, his inter-temporal optimization
problem is given by:
Max
c1,c2
_
c
1
1
1
+
c
1
2
1
_
subject to
c
1
+
c
2
R
= y
1
+
y
2
R
(3a)
Setting up the Lagrangian L ,we get
L =
c
1
1
1
+
c
1
2
1
+
_
y
1
c
1
+
y
2
c
2
R
_
(4)
First order conditions are given by :
L
c
1
= c

1
= 0 (5a)
L
c
2
= c

2


R
= 0 (5b)
Using 5a and 5b we get ,
c
2
c
1
=

R (6)
Putting (6) into (3a) we get ,
c
1
+c
1

R
R
= y
1
+
y
2
R
c
1
_
_
_1 +R

_
_
_ = y
1
+
y
2
R
c
1
=
y
1
+
y
2
R
_
_
_1 +R

_
_
_
(7a)
Since s = y
1
c
1
where y
1
is constant and dr = dR we get
ds
dr
=
dc
1
dr
=

dc
1
dR
. Using (7a) we get,
c
1
=
y
1
1 +R

1
+
y
2
R +R
1

dc
1
dR
=
y
1
_
_
_1 +R

_
_
_
2
_
1

1
_
_
_
R
1

2
_
_
+
y
2
_
_
R +R
1

_
_
2
_
_
1 +
1

R
1

1
_
_

dc
1
dR
=
1
_
_
R +R
1

_
_
2
_
_
_
1

1
_
y
1
R
1

+y
2
_
_
1 +
1

R
1

1
_
_
_
_

dc
1
dR
=
1
_
_
R +R
1

_
_
2
_
_
1

_
y
1
+
y
2
R
_
R
1

_
_
y
1
R
1

y
2
_
_
_
_
(8)
From eqn. (8) we see that if second term inside the square brackets, y
1
R
1

y
2
0 then
ds
dr
=
dc
1
dR
> 0 always. Again using (7a), we get:
y
1
c
1
=
1
R +R
1

_
_
y
1
R
1

y
2
_
_
(9)
So y
1
R
1

y
2
0 implies y
1
c
1
0. In other words if y
1
c
1
0 then
ds
dr
> 0 always. That is, if consumer is a net borrower in the rst period
his (saving)borrowing (increases)decreases with rise in interest rate. This is a
sucient condition but not necessary.
If this condition is not satised period 1 saving may increase or decrease with
rise in interest rate. If the consumer is net saver in the rst period, whenever
interest rate increases two eects come into force. Since the consumers savings
gives him more income in second period, he can increase consumption in both
the period. This is called income eect. However consumption in second period
is now cheaper than consumption in rst period. Thus consumer can achieve
higher overall utility if he can consume more in second period instead of rst
period. This is called substitution eect. When interest increases both of these
tend to increase consumption in second period. However in the rst period
income eect will tend to increase consumption and substitution eect will tend
to decrease it. Which of these eect dominates and whether net eect is positive
or negative depends on the consumer preference( here by the value of ). In the
gures below we present two scenarios. In both the gures black arrow shows
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income eect and brown arrow shows substitution eect. In the gure on the
left consumption decreases in the rst period and saving increases. In the gure
on the right consumption increases in the rst period and saving decreases.
Problem 3. We are using here the same model as in problem 2 , except that
now y
1
= 100 and y
2
= 0. Also we know that R = 1 + r > 1. Putting these
values into (7a) we get:
c
1
=
100
_
_
_1 +R

_
_
_
Then c
1
50 i
2 1 +R

1 R

0
1

1
1
1

1
So c
1
= 50 if = 1, c
1
< 50 if < 1 and c
1
> 50 if > 1.
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