Question

3) Suppose the real interest rate falls in the two-period model (where income and taxes are exogenous). Consider the income and substitution effects and explain in words and through diagrams how this change affects current consumption, future consumption, and savings of a consumer who is a

a) lender

b) borrower

c) Which type of consumer (lender or borrower) becomes better off after the interest rate change? Explain in words.

Answer 1

Q.c) Which type of consumer (lender or borrower) becomes better off after the interest rate change? Explain in words.

Ans-

The borrower becomes the better consumer after the interest rate change. The interest rate is a big factor for the borrowers,i.e. when the rate of interest decreases then the borrower pays less interest, which gives them plenty of money to expand, which generates a ripple effect throughout the economy of increasing spending.

Q. Suppose the real interest rate falls in the two-period model (where income and taxes are exogenous). Consider the income and substitution effects and explain in words and through diagrams how this change affects current consumption, future consumption, and savings of a consumer who is a

a) lender

b) borrower

Ans-

Optimal consumption bundle is at the tangency of indifference curve to budget constraint
At Figures, the endowment point is at E, but the consumer chooses to point A
At Point A
MRSc1,c2=1+r
Consumer lends distance DB that is s1=y1-t1-c1*>0(fig 1)
Consumer borrowers distance DB that is s1=y1-t1-c1*<0(fig 2)