Two-Period Consumption Model Quiz

Study Notes

Two-Period Consumption Model

Two investors, A (patient) and B (impatient), with $200,000 income at t=0 and none at t=1.
Both have access to a real investment with a $200,000 cost now and a $215,000 guaranteed return at t=1.
Risk-free borrowing/lending at 10% annually.

Investor A (Patient)

Real Investment Decision: A will invest the full $200,000 in the real asset.
Financial Investment Decision: A will not borrow or lend any additional money.
Resultant Cash Flows:
- t=0: -$200,000 (investment cost).
- t=1: $215,000 (return).
Resultant Consumption: A will save all income and consume the $215,000 return at t=1.

Investor B (Impatient)

Real Investment Decision: B will invest in the real asset.
Financial Investment Decision: To maximize current consumption, B will borrow to invest in the real asset. This is because they value present consumption more.
Resultant Cash Flows:
- t=0: -$200,000 (investment cost) + the amount borrowed.
- t=1: $215,000 (selling the return) - the borrowed amount - the interest on the borrowed amount.
Resultant Consumption: B will consume a larger amount today by borrowing to invest the maximum amount in the real asset.

Net Present Value (NPV) Rule

NPV rule suggests that projects with positive NPV should be undertaken.
Investor A's maximum consumption at t=1 and investor B's max current consumption result in a positive NPV.
The NPV rule is optimal in this context since it suggests undertaking the investment.
Important Note: The NPV rule assumes risk-free cash flows and can be a useful tool for decision-making under such circumstances.

Description

Test your understanding of the Two-Period Consumption Model through this quiz focused on investors A and B. Analyze their investment decisions, cash flows, and consumption strategies based on their patience levels. Dive into the concepts of borrowing, lending, and return on investments to enhance your economic knowledge.