show the effect of a decrease in the interest on current and future consumption for a...

show the effect of a decrease in the interest on current and future consumption for a lender and borrower. What is the overall effect of a decrease in the interest rate on current consumption?

Solutions

Expert Solution

Decrease in r for lender: substitution effect- since relative price of future consumption is higher , present consumption will be increased, future consumption will be decreased.

Decrease in r for lenders: income effect- since consumers are poorer and goods are normal, present and future consumption will be decreased.

That is for lenders current consumption depends on relative weight of IE and SE. Future consumption will be decreased.

Decrease in r for borrowers: substitution effect- since the relative price of future consumption is higher, current consumption will be increased and future consumption will be decreased.

Income effect: since the borrowers are richer and goods are normal, current and future consumption will be increased.

So total effect of borrowers , current consumption will be decreased and future consumption is ambiguous.

So overall impact on current consumption depends on lenders' weight of IE and SE.

if IE>SE present consumption will be decreased

if IE<SE present consumption will be increased.

Rahul Sunny answered 1 year ago

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