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One of the fundamental equations of modern macroeconomics (and modern finance) is the consumption Euler equation. Question 2 shows how to formally derive an Euler equation for a particular utility function, but here we can try and derive it by economic reasoning. We can use the no-arbitrage reasoning that we used for investment. Suppose that you have $1 and your options are to spend the money on some additional consumption today (period 1) or some additional consumption tomorrow (period 2). There is no uncertainty and no inflation. In order to proceed, we need to think about how we value consumption over two periods. The standard approach is to assume that utility is additively separable over time; that is, our utility function looks like: U(C, C2) = "(C) + Bu(c2), B20 where u(.) is the period or instantaneous utility function. The parameter S is very important. It is the subjective discount factor: the consumer's way of dis- counting future utility. Another way to express this is to introduce the subjective discount rate, p where B = 1/(1 + p). The parameter p is the consumer's own personal interest rate. Although we have specified that S be greater than or equal to zero, in practice we normally work with 0