Question

a) What are the two channels through which an increase in the real interest rate affects

consumption decisions?

(b) Suppose your income in year 1 is $1,000 and in year 2 it increases to $1,100. If you

choose your income following the PIH how much should you consume in each year?

(c) Show graphically what happens to consumption after a fall in permanent income using

the indifference curve/budget constraint graph.

(d) Show what happens to the consumption demand curve after a fall in permanent income.

You should use your answer to questions 4 in answering this question.

Answer 1

A). If the real interest rate increase then consumption levels decreases in an economy
A higher real inerest rate has two specific effects:
a) Saving levels in the economy experience a positive substitution effect as higher levels of saving are rewarded by a higher level of return in the form of higher ineterest.
b) Saving levels in the economy experience a mixed income effect when real interest rate rises.
i) it is negative for target savers (i.e. net savers) as they require lesser savings to reach the targeted corpus at the end of the saving period.
ii) it is positive for net borrowers as increase in real interest rate signifies loss of net wealth.
Hence, an increase in real interest rate actually encourages higher saving and lesser borrowing thus decreasing levels of consumption in the economy.

B). PIH or permanent income hypothesis assumes people tend to smoothen their consumption levels through periods of uneven incomes. People tend to relate their consumption with what they assume to be their "normal" income which could be an average of past incomes or an average of future income streams. Hence, an autonomous investment in a particular period and cosnequent increase in income in that period might not have a steady multiplier effect.
If my income is $1,000 in year 1 and it increases to $1,100 in year 2 and if I follow PIH, I would consider my income to be an average of incomes of these two years and assume it to be (1,000+1100)/2 = $1,050. My consumption would depend upon the MPC and would be MPC X 1050. As MPC < 1, my consumption would be lesser than $1,050 and there would be positive saving.
C).

D).

If interest rate falls, consumption increases thus giving the consumption curve C a negative slope.