Janet Knows That She Will Ultimately Face Retirement

Essay

Janet knows that she will ultimately face retirement. Assume that Janet will experience two periods in her life, one in which she works and earns income, and one in which she is retired and earns no income. Janet can earn $250,000 during her working period and nothing in her retirement period. She must both save and consume in her work period and can earn 10 percent interest on her savings.
a. Use a graph to demonstrate Janet's budget constraint.
b. On your graph, show Janet at an optimal level of consumption in the work period equal to $150,000. What is the implied optimal level of consumption in her retirement period?
c. Now, using your graph from part b above, demonstrate how Janet will be affected by an increase in the interest rate on savings to 14 percent. Discuss the role of income and substitution effects in determining whether Janet will increase, or decrease her savings in the work period.
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