Dorothea Brooke has given her nephew the following choice. He can choose between two different bundles. Bundle F consists of $100 tomorrow and $10 today. Bundle P consists of $30 tomorrow and $60 today. Her nephew can borrow and lend money at an interest rate of 15%. Consumption goods have a price today of $1 per unit and there is no inflation.

a. What is the present value of each of the two bundles? What is the future value of each of the two bundles?

b. Which bundle do you think the nephew should choose? Why? [ Hint: A diagram which illustrates combinations of C₁and C₂which are affordable for each bundle might be helpful.]

c. Bankers recognize that perfect capital markets make it difficult to make money by lending money. Thus, they will now pay the nephew 15% for any amount he lends them and they will charge him 50% interest on any amount he borrows. Which bundle will the nephew choose? Why? Again, a diagram which illustrates combinations of C₁and C₂ which are affordable for each bundle will be helpful.