ECONOMICS

Consider the Consumption and Savings model with random future income. The utility function of the individual is: u(C₀, C₁) = (C₀) (C₁)^1/2,where C₀ is present consumption expenditure and C₁ is future consumption.Let the present income be $1,000, the interest rate in the financial market r = 5%,and the probability distribution of future incomeY~₁ = (500, 1000; 21 , 21 )

1. Using the expected utility approach, rank the alternatives of saving $0 (consume $1,000 in the present) vs borrowing $100 in the present.

2. Using the expected utility approach, rank the alternatives of saving $400 vs saving $300.

Now assume that the distribution of future income isY~₁ = (200, 1000; 21 , 21 ).

3. What type of change in risk did the distribution of future income suffer? Why?

4. Is there any change in the rankings obtained in questions 1 and 2 above?