Scribd
Upload
3 views16 pages

A Two Period Model: The Consumption-Savings Decision and Credit Markets

Uploaded by

Manan Mehta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
3 views16 pages

A Two Period Model: The Consumption-Savings Decision and Credit Markets

Uploaded by

Manan Mehta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 16

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS

DECISION AND CREDIT MARKETS

CHAPTER 9
An Increase in Real Interest Rate

▶ Consider an increase in the real interest rate r


1
▶ Because 1+r is the relative price of future consumption goods in terms of current
consumption goods, a change in the real interest rate effectively changes this
intertemporal relative price.
▶ Has income and substitution effects
▶ Similar to effect of increasing wage in consumption-leisure model

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 1 / 15


An Increase in the Real Interest Rate

▶ Under the assumption that the consumer never has to pay a tax larger than his or her
income, so that y ′ − t′ > 0, an increase in r decreases lifetime wealth we:

we(1 + r) = (y − t)(1 + r) + y ′ − t′

▶ Because y > t, there is an increase in we(1 + r) when r increases


▶ Therefore, an increase in r causes the budget constraint to pivot
▶ The budget constraint must pivot around the endowment point E, because it must always
be possible for the consumer to consume his or her disposable income in each period, no
matter what the real interest rate is.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 2 / 15


An Increase in the Real Interest Rate

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 3 / 15


An Increase in the Real Interest Rate

▶ A change in r results in a change in the relative price of consumption in the current and
future periods
▶ An increase in r causes future consumption to become cheaper relative to current
consumption
▶ A higher interest rate implies that the return on savings is higher, so that more future
consumption goods can be obtained for a given sacrifice of current consumption goods.
▶ For a given loan in the first period, the consumer has to forgo more future consumption
goods when the loan is repaid.
▶ The income effects of an increase in the real interest rate work in different directions for
lenders and borrowers

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 4 / 15


Lender

▶ Consider a consumer who is initially a lender and faces an increase in the market real
interest rate from r1 to r2 .
▶ Initially, lifetime wealth is we1 , and this changes to we2 .
▶ The budget constraint pivots around the endowment point E.
▶ Initially, the consumer chose the consumption bundle A, and we suppose that the
consumer chooses B after the increase in the real interest rate.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 5 / 15


An Increase in the Real Interest Rate for a Lender

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 6 / 15


Lender

▶ SE: A to D
▶ IE: D to B
▶ A to D: c decreases, c′ increases
▶ This is because future consumption has become cheaper relative to current consumption.
▶ D to B: c increases, c′ increases
▶ Therefore, future consumption must increase, as both the income and substitution effects
work in the same direction.
▶ However, current-period consumption may increase or decrease

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 7 / 15


Lender

▶ If IE > SE, then current consumption increases


▶ The effect on savings depends on the change in current consumption, as we are holding
constant current disposable income.
▶ If IE > SE, savings decreases
▶ If IE < SE, savings increases
▶ An increase in the real interest rate makes saving more attractive, because the relative
price of future consumption is lower (the substitution effect), but it makes saving less
attractive as there is a positive income effect on period 1 consumption, which tends to
reduce saving.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 8 / 15


Lender- Numerical Example
▶ Suppose Christine is currently a lender, whose disposable income in the current year is
$40,000. Her income next year will also be $40,000 (in current year dollars)
▶ She currently saves 30% of her current income, and she faces a real interest rate of 5%.
▶ So initially her current period consumption= 0.7 *$40,000 = $28,000
▶ Future period consumption= $40,000 + (1 + 0.05) * $12,000 = $52,600
▶ Now, suppose that the real interest rate rises to 10%.
▶ If she continues to consume $28,000 in the current year and saves $12,000, then she has
future consumption of $53,200, an increase over initial future consumption, reflecting the
substitution effect.
▶ However, if she consumes the same amount next year, she can now save less in the
current year to achieve the same result. That is, she could save $11,454 in the current
year, which would imply that she could consume $52,600 next year.
▶ Then, she consumes $40,000-$11,454 = $28,546, which is more than before, reflecting
the income effect.
▶ What Christine does depends on her own preferences and how strong the relative income
and substitution effects are for her as an individual
A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 9 / 15
Borrower

▶ Now consider a consumer who is initially a borrower and faces an increase in the market
real interest rate from r1 to r2 .
▶ Initially, lifetime wealth is we1 , and this changes to we2 .
▶ The budget constraint pivots around the endowment point E.
▶ Initially, the consumer chose the consumption bundle A, and we suppose that the
consumer chooses B after the increase in the real interest rate.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 10 / 15


An Increase in the Real Interest Rate for a Borrower

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 11 / 15


Borrower

▶ SE: A to D
▶ IE: D to B
▶ A to D: c decreases, c′ increases
▶ This is because future consumption has become cheaper relative to current consumption.
▶ D to B: c decreases, c′ decreases
▶ Thus current consumption falls for the borrower
▶ Future consumption may rise or fall
▶ Savings must rise, as current consumption falls and current disposable income is held
constant.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 12 / 15


Borrower - Numerical Example

▶ Suppose that Christopher is initially a borrower, whose income in the current year and
next year is $40,000 (in current year dollars).
▶ Initially, Christopher takes out a loan of $20,000 in the current year, so that he can
consume $60,000 in the current year.
▶ The real interest rate is 5%, so that the principal and interest on his loan is $21,000, and
he consumes $19,000 next year.
▶ Now, suppose alternatively that the real interest rate is 10%.
▶ If Christopher holds constant his consumption in the future, this must imply that his
current consumption goes down, reflecting the negative income effect.
▶ That is, if he continues to consume $19,000 next year, given a real interest rate of 10%,
he can borrow only $19,091 this year, which implies that his current year consumption is
$59,091.

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 13 / 15


Lenders vs Borrowers

A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 14 / 15


Lenders vs Borrowers
▶ For both lenders and borrowers, there is an intertemporal substitution effect of an
increase in the real interest rate
▶ A higher real interest rate lowers the relative price of future consumption in terms of
current consumption, and this leads to a substitution of future consumption for current
consumption and, therefore, to an increase in savings.
▶ Thus there are potentially confounding income effects in determining the effect of an
increase in the real interest rate on aggregate consumption.
▶ The population consists of many consumers, some of whom are lenders, and some of
whom are borrowers. Though consumption decreases for each borrower when the real
interest rate goes up, what happens to the consumption of lenders depends on the
strength of opposing income and substitution effects.
▶ Though there is a tendency for the negative income effects on the consumption of
borrowers to offset the positive income effects on the consumption of lenders, leaving us
with only the substitution effects, there is no theoretical guarantee that aggregate
consumption will fall when the real interest rate rises.
▶ Problematic for monetary policy
A TWO PERIOD MODEL: THE CONSUMPTION-SAVINGS DECISION AND CREDIT MARKETS 15 / 15

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy