Problem 1: Ali inherits $10,000 from his great-great aunt in 2008. His great-great aunt’s will require that Ali spend the money before December 31, 2009. He has two spending options: He can spend the amount either in 2008 or in 2009. Suppose this is Ali’s only source of income and the interest rate on loans or savings is 10 percent. (a) How much could Ali spend in 2008 if he only consumes in 2008? How much could Ali spend in 2009 if he only consumes in 2009? (b) What is the opportunity cost of consuming $1.00 in 2008 in terms of forgone consumption in 2009? Draw Ali’s budget constraint and optimal consumption bundle, considering that the spending in 2008 is measured along the horizontal axis. (c) Ali decides to spend $6,000 in 2008 and $4,400 in 2009. Show this optimal consumption bundle using a budget constraint and indifference curve diagram.
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