Question

A consumer receives his income in two periods, can save or borrow, and views a unit of

consumption in period 1 as a perfect substitute (one for one) for a unit of consumption in period 2.

If the nominal interest rate is 5% and the inflation rate is 6%, the consumer will:

a. Consume only in period 1.

b. Consume only in period 2.

c. Consume equal amounts in each period.

d. Consume more in period 1 than in period 2 if income elasticity exceeds 1.

e. Equalize expenditures but not consumption in the two periods.

Answer 1

We know that

nominal rate = real interest rate + inflation rate,

If the nominal interest rate is 5% and the inflation rate is 6%

Real rate = nominal rate- inflation rate = 5 -6 = -1%

the real interest is negative than a rational consumer will choose to save so the consumer will be lender at period 1.

It means real interest rate is negative, then a unit of current consumption can be had for the sacrifice of less than 1 unit of future consumption.

so option A is the right answer.