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ECON200 QUIZ2 - Quiz 2-Econ 200A 30 points Time allowed 24...

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Quiz 2-Econ 200A Fall 2009 30 points- Time allowed: 24 minutes Answer Key 1. a. Explain why individuals have a tendency to smooth out their consumption over time. Use a graph (or two graphs) to both explain and give an example of this behavior. (10 points) When consumption is “smoothed” over the horizon with volatile incomes, people receive a higher total value than when their consumption oscillates. This is shown by the graph below. The MV of present consumption –in terms of tomorrow’s consumption forgone-- is declining: The analysis here shows that people’s TOTAL VALUE of a Smooth consumption is higher than that of a volatile consumption. In other words, the total value of smooth consumption over two years is higher then the total value of volatile consumption in the same two years, even though the average consumption would be the same for both cases. Therefore if individual’s income is volatile and they like consume the same ( smooth consumption pattern) each year, they will “lend” some of their income (i.e., not consume it) when
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