A. Consider the two-period model of consumption in which an individual faces the following budget constraint: y(1+r) + y'= c(1+r) + c'. Assume that she would like to consume equal amounts in each period.

1. If the individual earns y in the period 1 (the first stage) of her life, and y'= 0 in period 2 (the second stage of her life), when she retires, what is her budget constraint? Find the expression for optimal consumption in each period, and current period saving. Depict these on a graph. (4 points).

2. Suppose that in addition to her income of y in the current period, this individual is assured of an income of y' > 0 in period 2, when she retires. How would this change her optimal consumption in each period, and the amount she saves in the current period? Show the changes in your graph. (4 points)

B. Consider a small open economy that faces an increase in the world rate of interest. Suppose that at the new optimum, current period consumption is unchanged. From this we can conclude that this nation must be a lender and not a borrower. Do you agree? Explain and support your answer with graphs.