When r rises the price of period 1 income increases

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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 increases. •  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 effect be? 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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