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When households receive news of a future income reduction, their responses vary based on their time preferences. A forward-looking, consumption-smoothing household will immediately reduce its spending to maintain a stable consumption level over time. In contrast, a household with a present bias, driven by a desire for immediate gratification, may not react to the news at all. They will likely continue consuming all of their current income, leading to a drastic drop in consumption only after the income itself falls.

Comparing Consumption Smoothing and Present Bias in Response to Future Income Decrease

Analyze how Maria's consumption is likely to change *this month* if she is a forward-looking individual who prefers a stable lifestyle, compared to David's consumption change *this month* if he tends to prioritize immediate satisfaction. Justify your reasoning for each person.

Household Spending Decisions in Response to Future Events

Imagine two individuals, Alex and Ben, both learn today that they will receive a significant, permanent pay cut one year from now. Alex immediately reduces their current spending, while Ben's spending remains unchanged until the pay cut actually happens. Based on these behaviors, identify which individual is likely a 'consumption-smoother' and which exhibits 'present bias'. Justify your answer by explaining the core reasoning behind each individual's decision-making process.

Contrasting Reactions to Future Income Shocks

Imagine two households, Household A and Household B. Both receive credible news today that their income will be permanently cut by 30% in exactly one year. Household A immediately reduces its current spending. Household B makes no change to its current spending. Analyze the behavior of both households and evaluate the likely consequences for each household's standard of living in the year *after* the income cut takes effect. Justify which household's approach leads to a more stable financial outcome.

Evaluating Household Responses to Future Income Shocks

An individual learns today that their stable, high-paying job will be eliminated in one year, after which they will have a permanently lower income. If this individual has a strong present bias, which of the following best describes their likely consumption pattern over the next few months?

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