2. (40 points total) Dagwoods neighbor, Homer Simpson, does not abide by the life cycle theory of consumption. Homer has a lets live life like its our last day mentality and thus, he prefers to consume more today, relative to the future. In particular, Homer prefers to consume exactly twice as much today (c), relative to consumption next period (c^f). Homers current income equals $200K and his future expected income = $200K. He has no wealth (neither current nor expected) since he lives like today is his last! Homer faces an initial real interest rate of -0.03, just like our friend Dagwood. Please answer the following questions.

a) (5 points) Solve for Homers optimal consumption basket today (C*) and his optimal consumption basket next period (C^f*). Please provide a completely labeled graph depicting these results and label this point as C*_A.

(15 points for a completely labeled graph be sure to label the no lending / no borrowing point = NL/NB and the slope of each budget constraint)

b) (5 points) Homer goes to work and the rumor being spread around the work place is not good. Homer works in the green energy field and given the new head of the EPA, green energy grants are being cut. Homer is forced to take a pay cut so that his current income (Y) falls to $150K. The boss assures Homer that this cut in his current income is temporary so that his future income (Y^f) is unchanged and still equals $200K. Recalculate the optimal bundle for Homer and add this point to your graph and label as point C*_B. Is Homer worse off or better off? Explain (hint, what has happened to his budget constraint (aka opportunity set)).

c) (5 points) In steps Janet Yellen and the Fed. Given that the economy appears to be on sound footing, the Fed raises interest rates so that the real rate of interest rises to 0.05. Recalculate the optimal bundle for Homer and add this point to your graph and label as point C*_C. (Note, point C*_C incorporates the shock to Homer's current income in part b))

d) (10 points) Is Homer better or worse off due to the fall in the real rate of interest? Explain being sure to discuss exactly how the substitution and income effects play a role in Homer's consumption decisions. Also, comment on whether these income and substitution effects work in the same or opposite direction (i.e., is it a tug of war or do they work in the same direction?) in this particular case. Please include actual numbers when discussing the income and substitution effects or points will be taken off.