Ok this EOC is tripping me up…
Blake inherited a sizable amount of money-
- Holding all else constant, the change in Blake’s income will most likely result in:
- an increase in his marginal utility of consumption.
- an increase in his intertemporal rate of substitution.
- a decrease in his required risk premium for investing in risky assets
Now i get why C is the answer. But if i picture the intertemporal rate of substitution formula i see answer B. if current marginal utility goes down (as per the answer), then the ITRS will go up, and rates will fall. So dont B & C really go together? Struggling to understand this. Id really appreciate an ELI5 on this, or just a solid explanation on how these are related and how they tie together the ITRS and the risky rate.
Hey there so see it like this. If my income goes up or if am expecting to earn say twice of what am earning next week or say next year, wouldn’t you derive utility out of current consumption as you know whatever you spend today will be recovered next week or 1 year down the line ? If you know the answer to this question, you know that ITRS will fall.
The reason I’ll demand a lower premium is cause I have decent amount of liquidity and am willing to take on additional risk which is backed by my surplus liquidity for which I won’t demand a premium.
Makes sense ?
that makes sense. what im struggling to understand tho is how the fomula for ITRS ties into it- if he gets more money today, then his current marginal utility will fall because hes rich. that means the denominator of the fomula is decreasing right? which means that the ITRS should go up? or is the future marginal utility decreasing because he’ll have money in thee future, therefore lowering the numerator and causing the ratio to fall?
If he gets more money today, he will spend more today, which will lead to an increase in marginal utility out of “CURRENT” consumption not future consumption. Because of that incremental liquidity he now has, he can afford to spend it now than postpone current consumption. Put yourself in his shoes and ask yourself what would you do.
i think im just misunderstanding what marginal utility of consumption means, hence my inability to connect the dots. Marginal utility of consumption= how much utility you get from consuming right? so if you have a lot of money today, you wont need to save for the future. So, your intertemporal rate of substitution is low. This means that current consumption is more important to you than future consumption (LOWER future marginal utility and HIGHER current marginal utility). Do i have this right? thanks for responding btw.
Almost. I wouldn’t say current consumption is more important but its how humans are. Empower them with wealth and they’d spend it today rather than in the future.
Ew, wont be tested. One question max if so.