4.7 Suppose a consumer has a two-period utility function of the form labelled type A in Exercise 4.2. where xi is the amount of consumption in period i. The
consumer's resources consist just of inherited assets A in period 1, which is partly spent on consumption in period 1 and the remainder invested in an asset paying
a rate of interest r.
1. Interpret the parameter a in this case.
2. Obtain the optimal allocation of (xl, x2)
3. Explain how consumption varies with A, r and a.
4. Comment on your results and examine the “income” and “substitution” effects of the interest rate on consumption.
