Question

1. Sabrina – an individual – is a lender at the initial interest rate.

a. Show the inter-temporal budget constraint and outline Sabrina’s optimal choice of consumption in period 1 and 2 on a diagram. Explain your answer.

b. Interest rates increase. Show the changes on the diagram that ensue. If Sabrina remains a lender, is she better or worse off? Explain your answer. Is it possible for Sabrina to lend more than he did with the lower interest rate? Explain your answer.

c. After the interest rate increase, is it possible for Sabrina to be better off than she was before the increase in interest rates. Explain.

Answer 1

a) Initial budget constraint is AB where current consumption is C0 and future consumption is F0 in the diagram above.

b) If interest rate rises, people tends to save more money and consume less. If will shift the intertemporal budget constraint to CD where current consumption reduces to C1 and future consumption rises to F1.

If she remains a lender, she is better off by lending as she will get more money for the amount he lend.

For Sabrina to lend more money when rate of interest rises, it actually depends upon whether he can reduce his current consumption or not.

c) It makes Sabrina better off as it shifts him on higher indifference curve from IC0 to IC1 where higher indifference curve shows higher utility.