Question 1 (10 marks)

Explain the assumption regarding consumers' behavior in the life-cycle-permanent-income hypothesis which needs to be changed in order to explain the presence of precautionary, or buffer-stock saving.

Question 2 (10 marks)

Say Ali defines his permanent income as the average income this year and the past 4 years' incomes. Furthermore he always consume 3/5 of his permanent income. His incomes record over these years has been:

Y_t= 46,000

Y_t-1 = 42,000

Y_t-2 = 36,000

Y_t-3 = 32,000

Y_t-4 = 30,000

If next year his income increases to Y_t+1 = 50,000 by how much will Ali's consumption change between year t and year t+1?