Let’s work out a simple example where a person smoothes her consumption over time. Gwen is a real estate agent, and she knows that she will have some good years and some bad years. She figures that half the time she’ll earn $90,000 per year, and half the time she’ll earn $20,000 per year. These numbers are after taxes and after saving for retirement. These numbers are all she has to worry about.
a. If we ignore interest costs just to keep things simple, how much should Gwen consume in the average year?
b. How many dollars will she save during the good years?
c. How many dollars will she borrow during the bad years? (Note: “Borrowing,” in this context, is basically the same as “pulling money out of savings.”)