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Unformatted text preview: Rewriting this: • Does this look at all familiar?
1011a – Lecture 8 21 The Intertemporal Slutsky Equation • Remember that r is the price in this equation.
• So when we change it, there should be a price
and an income effect.
1011a – Lecture 8 22 The Substitution Effect • This term is always negative.
• When r rises, the price of period 1 income
• So you substitute towards period 2.
1011a – Lecture 8 23 The Income Effect (I) • We said earlier that consumption in both
periods is a normal good.
• So what should the sign of the income
1011a – Lecture 8 24 The Income Effect (II) ? always > 0 • It depends on whether a rise in the interest
rate made you richer or poorer.
• This depends on whether you were a
borrower or a lender.
1011a – Lecture 8 25 The Income Effect (III) ? always > 0 • If y1 > c1 you are a lender, so the rise made
you richer, so you consume more c1.
• If y1 < c1 you are a borrower, so the rise
made you poorer, so you consume less c1.
1011a – Lecture 8 26 The Interest Rate: Summary
• When interest rates rise: • The price of first period consumption rises, so everyone
substitutes away from period 1 towards period 2. • Borrowers are made poorer, so this also decreases their
period 1 consumption. Hence their overall period 1
consumption decreases. • Lenders are made richer, so this increases their period 1
consumption. The overall effect on their period 1
consumption is ambiguous. 1011a – Lecture 8 27 Changes in the Discount Factor
• Now, let us find . c2 • Hence: • What will happen to c2?
1011a – Lecture 8 28...
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- Spring '11