Question

For a consumer who is initially a borrower, use a budget line-indifference curve diagram to analyse the effect of an increase in the real interest rate. You can use one diagram to answer part (a) and (b) together.

a) In your diagram, please indicate the no borrowing-and-no lending point, and indicate the optimal consumption point. [4 marks]

b) In your diagram, clearly show the income and substitution effects

Answer 1

IN AN INDIFFERENCE CURVE SCHEDULE EQULIBRIUM OCCURES WHERE BUDGET LINE IS TANGENTIAL TO INDIFFERENCE CURVE. ALONG AN INDIFFERENCE CURVE UTILITY OR SATISFACTION IS EQUAL FOR AL COSUMPTION OR BORROWING. THE DIAGRAMS ARE ATTACHED BELOW:

IMAGE 1

a)

b)

PRICE CHANGES DUE TO TWO REASONS. EITHER CHANGE IN SUBSTITUTE DEMAND OR CHANGE IN PRICE. HERE DUE TO CHANGE IN SUBSTITUTE DEMANE BUDGET LINE HAS MOVED FROM BB₁ TO MN AND IS TANGENTIAL TO SAME INDIFFERENCE CURVE. THIS MEANS BY SUBSTITUTE GOOD CONSUMER RECIEVES SAME SATISFACTION. NOW DUE TO CHANGE IN INCOME BUDGET LINE HAS SHIFTED TO BB₂ AND IS TANGENTIAL TO A HIGHER IC. THIS MEANS BY CHANGE IN INCOME CONSUMER HAS STARTED DERIVING HIGHER SATISFACTION. THIS PHENOMENON IS DEPICTED IN THE FIGURE ABOVE.