Abby lives and works for two periods. In the first period, she earns 1,000 coconuts while in the second she earns 2,200 coconuts. Abby can save or borrow from a bank at the same interest rate of 10%. Abby also owns a 550 sq.ft. apartment, priced at 2 coconuts per square foot. She cannot sell it in the first period because she needs a place to stay in the second, but she can borrow against it and sell it in the second.
Abby lives and works for two periods. In the first period, she earns 1,000 coconuts while in
the second she earns 2,200 coconuts. Abby can save or borrow from a bank at the same interest
rate of 10%. Abby also owns a 550 sq.ft. apartment, priced at 2 coconuts per square foot. She
cannot sell it in the first period because she needs a place to stay in the second, but she can
borrow against it and sell it in the second.
a. In a graph that has future consumption on the vertical axis and current consumption on
the horizontal, show how her lifetime budget constraint would look if banks do NOT require
collateral. Make sure to compute and show the coordinates of the vertical and horizontal
intercepts as well as those of the endowment point (which in the second period should
include her house).
b. Suppose that Abby likes to consume 2,400 coconuts in the first period. Could she do that
if banks do not require collateral? Would the outcome be Pareto optimal and why?
c. Suppose now that banks do require collateral to lend. Repeat parts a and b.
d. How does the need for collateral affect her current consumption and welfare? Explain!
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