Question

Suppose there are two closed economies: Economy A and Economy B. Economy A has a high average rate of time preference relative to economy B’s low average rate of time preference.

(1) Describe the differences you would expect to see with respect to interest rates and levels of investment in the two economies. (2) Describe what would occur if these countries were open to international capital flows. (This is the key to answering Bernanke’s question)

Answer 1

Solution:-
a) The higher the time preference, the higher the discount placed on returns receivable or costs payable in the future. The time preference that an individual exhibits at any given moment is determined solely by their personal preferences. As such, if time-preference is more and the interest rate is also high then one prefers to save his money. If time-preference is less and the interest rate is also less then one prefers to save his money but cannot do so in the present, he is still considered to have a low time-preference. One of the factors that may determine an individual's time preference is how long that individual has lived. An older individual may have a lower time preference than a younger one.

b) If time-preference is more and then the international capital flow increases and the investment also increases. If time-preference is less and then the present investment is low, so the international capital flow is less and the investment also less.

Hope it helps you.