PAM 200 10.10 - PAM 200 Two Period Model Income(I in Period...

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PAM 200 10/10/07 Two Period Model: Income (I) in Period 1 Only How much to consume in P1 and P2 If you consume all your income in P1, C1= I + C2=0 If you save everything: C1=0 and C2= I(1+i) Generally C2= (I-C1)(1+i)= I(1+i) – (1+i)C1 C2=I(1+i) – (1+i)C1 is the BC What happens if the interest rate increases to I’? :
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There are two effects: Income and Substitution To find SE: take new IC Curve and shift it to where its tangent with the first IC curve C1: Substitution induces us to consume less
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Unformatted text preview: Income effect induces us to consume more C2: Substitution effect induces us to consume more Income effect induces us to consume more Therefore, if Interest rates go up we consume more in the future, and maybe in the present period (depending on strength of IE effect) Lets consider government intervention in the savings market: Government forces savings through social security paychecks To return to a point with more consumption borrow...
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