Question

The predicted sharp rise in consumer spending is attributed by economists to lower predicted savings. in the last few weeks,interest rates have fallen and consumer confidence to borrow has risen. using a consumption function diagram illustrate the expected effect.

Answer 1

C = Y - S

According to the economists, the cause of increase in consumer spending in decrese in savings as per above equation. Initially, E0 is the equilibrium point, where consumption in each period is equal to income of that period of the consumer.

Consumption in period 1 is C₁, income is Y₁ and Consumption in period 2 is C2, income is Y2 . r is the rate of interest.

C₁ = Y₁ - S₁

Now, C₂ = (1+r)S + Y₂

If C1 > Y1 , the consumer becomes a borrower ans s<0

C₂ = (Y₁ - C₁ )(1+r) + Y₂

=> (1+r)C1 + C₂ = Y₂ + (1+r)Y₁

=> C1 +  C₂ (1+r) = Y₁ + Y₂ (1+r)

The expected effect is that a borrower would be at the region below E₀ and the new equilibrium would be somewhere in the segment GE₀. Drop in interest rate induces the consumer to borrow more in period1. Therefore, consumption in period1 increases and as a result, future consumption in period 2 decreases. The effect has been depicted in the diagram using intertemporal consumption function.