Question

1. Using a two-period income - consumption diagram, show the impact on current savings of a fall in the interest rate. Assume that the individual saved part of her income in period 1

Answer 1

When the interest rate falls, people saves less for period 2 (Future) and they will raise their consumption in period 1 (Now) as money saved for Period 2 gives less return due to fallen interest rate. Initially the budget constraint is AB with Indifference curve IC1 where future consumption and current consumption is F1 and C1 respectively. When interest rate falls, budget constraint shifts to AC with Indifference curve as IC2 where future consumption have fallen to F2 and current consumption have risen to C2. As current consumption have increased, savings have fallen as Income is either saved or consumed.