Question

According to an article in The Economist (March 29, 2014), the government of China decided that Chinese people were saving too much, and therefore capped the interest rate that banks "can pay to depositors, imposing an implicit tax on their savings. But in China. . . this repression does not discourage saving. In fact, it appears to do the opposite."

Use the life-cycle model to depict a situation in which an individual saves more in response to a decrease in the interest rate. Specifically, draw the intertemporal budget constraint before and after the decrease in interest rates, and show how a rational individual might choose to increase saving in response to the decrease in interest rates. See if you can explain your answer intuitively.

Answer 1

Suppose you have the following inter-temporal budget constraing with curent year consumption on horizontal axis and future consumption on vertical axis. As you consume more in current period you borrow and if you save for future you get more to consume in future.

As a result of decrease in interest rate the budget line will pivot anti-clockwise indicating an ability to consume more in current period (since less interest needs to be paid on borrowing) and less in future (since you earn less on saving). While this may indicate an ability to consume more in current period, it doesn't mean that this is what the consumers would choose to do. They might just reduce their current consumption such that they are still able to consume as much in future as earlier. This means that they would save more than earlier since their savings earn less interest.