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:
Yt = 46,000
Yt-1 = 42,000
Yt-2 = 36,000
Yt-3 = 32,000
Yt-4 = 30,000
If next year his income increases to Yt+1 = 50,000 by how much will Ali’s consumption change between year t and year t+1?

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