Econ 352 YiLi Chien Intermediate Macroeconomics Spring 2011 Homework Assignment 4 Answer Question 1 (35 pts): Suppose Jill obeys the two-period model of consumption and earns nothing in the first period and $210 in the second period. In addition, she can borrow or lend at the interest rate r. a.(20 pts) What will happen to Jill’s consumption in the first period when the interest rate increases? Is Jill better off or worse off than before the interest rate increase? Show your result in graphs. Jill’s initial choice is describe in the following graph: Jill is a borrower. A higher interest rate makes her poorer, meaning that the income effect contributes to lower both C1and C2. But this also means that the relative price of consumption today is higher; according to the substitution effect, C1goes down and C2goes up. Therefore, C1surely decreases (income and substitution effects reinforce each other), but the impact of C2is ambiguous. C2 will go up (down) if the substitution (income) effect is dominant. In the following graph, the substitution effect is stronger. C1 C2 Y1+Y2/(1+r) A(1+r)Y1+Y2Y1= 0, Y2= 210
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