Claire is a borrower. When the real interest rate increases, will the substitution effect for consumption...
Claire is a borrower. When the real interest rate increases, will the substitution effect for consumption in period 2 be positive or negative? What about the income effect for consumption in period 2?
Homework Answers
An increase in real interest rate will have a positive income and
substitution effect of future consumption of a borrower.
That is, an increase in real interest rate will make a borrower consume more in period 2, both by income and substation effect.
This is because, going by substation effect, an increase in real interest rate will make consumption today expensive and thus consumption tomorrow cheaper. This leads to increase in consumption in future or period 2.
Coming to income effect, an increase in real interest rate will reduce relative income of borrower as he will pay more interest today. This will thus reduce his consumption today and increase consumption in future or period 2.
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