Take Home Quiz 8: Name: __________________________

Consider a utility function that is forward-looking. That is, a utility that is as a function of the probability between
economic prosperity and economic recession.
( , ) = V( ) + (1 ) V( )
( , ) = ln + (1 ) ln
Thus, ( ) = ln refers to the expected utility from consumption if there is economic prosperity (i.e. high level of
consumption) and ( ) = ln refers to the expected utility from consumption given an economic recession (i.e.
low level of consumption). Given that we only consider high consumption or low consumption, is the probability of
economic prosperity and (1 ) is the probability of economic recession. To put simply, the utility is the sum of the
two expected utilities given the probability of either prosperity or recession.
Since the consumer is forward-looking, the budget constraint therefore indicates the expected price levels in either
state of the economy.
= +
1. Set up the Lagrangian function for constrained utility maximization. Use the ln function. (3 points)

2. Get the first-order conditions. Solve for , , and . Make sure to use all three equations from the FOCs since
we have three unknowns. (10 points)

3. Interpret . (3 points)

4. Show how we can ensure that your solutions in number 3 maximizes utility. (3 points)