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Unformatted text preview: EC202 Summer Term Lecture Notes 1 Gabriele Gratton May 20, 2008 1 Readings Mankiw, Ch. 16 (16.5 and 16.6 optional) 2 The supply of savings of a lender Yesterday we have described the optimal behavior of an agent who lives for two periods and wants to decide how much to consume today and how much tomorrow. We have seen that when the interest rate changes the way our dude replies has two faces: the substitution effect and the income effect. SUBSTITUTION EFFECT r ↑ c 1 ↓ , c 2 ↑ , s ↑ r ↓ c 1 ↑ , c 2 ↓ , s ↓ INCOME EFFECT FOR A DEBTOR r ↑ c 1 ↓ , c 2 ↓ , s ↑ r ↓ c 1 ↑ , c 2 ↑ , s ↓ TOTAL EFFECT FOR A DEBTOR r ↑ c 1 ↓ , c 2 ? , s ↑ r ↓ c 1 ↑ , c 2 ? , s ↓ INCOME EFFECT FOR A LENDER r ↑ c 1 ↑ , c 2 ↑ , s ↓ r ↓ c 1 ↓ , c 2 ↓ , s ↑ TOTAL EFFECT FOR A LENDER r ↑ c 1 ? , c 2 ↑ , s ? r ↓ c 1 ? , c 2 ↓ , s ? For the rest of this class we are assuming that the substitution effects is dominant, i.e. when income and substitution effects go in different direction, 1 we assume that the substitution effect is stronger. We can therefore construct a demand curve for current consumption, c 1 as a function of the interest rate r . Let’s do it for a net lender. When the interest rate grows the lender wants to consume less today and more tomorrow, the demand curve will therefore be downward sloping. Since his current income y 1 does not change and savings is equal to s = y 1- c 1 , we can construct as well a supply curve for savings which will be increasing in r . Fig. 1 shows how to construct these two curves.....
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This note was uploaded on 01/28/2010 for the course EC CASEC202 taught by Professor Graton during the Spring '10 term at BU.
- Spring '10