ECON
ECON 110 Assignment 3

# ECON 110 Assignment 3 - 1st Year Econ Assignment Name(s...

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1 st Year Econ Assignment Name(s): Student #(s) Last, First (as printed on your student card) -in alphabetical order McCaul, Joshua 601 0470 Course: Economics 110 Section: B Instructor: Lorne Carmichael (optional) Assignment #: 3 Grade:_______

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Note: All the images in this assignment were hand drawn by me (Joshua McCaul), were scanned into a computer, and subsequently printed out. The exception is the first two graphs in question eleven which I drew using the tools available in Microsoft Excel. True, False, or Uncertain: A3-1. An increase in the rate of interest is certain to cause a household to save more for the future. This statement is false as it says that with certainty, a household will save more for the future if the rate of interest (r) increases. It is not certain as there is the possibility, dependent on income and substitution effects where someone may not save more for the future. The following graph illustrates this reality: On the above graph, CP = Consumption in Present, CF = Consumption in Future, I = Income, (1+r) = original interest rate, and (1+r r ) is the increased interest rate. The increase in r pivots the Budget Line around point I (because the interest rate does not affect your present Income, and thus does not affect Consumption in the present). However, the interest rate increase does make the present rate of consumption more expensive relative to that of the future, hence the budget Line (BL2) is steeper than the original (BL1). The initial substitution effect (denoted by S) moves consumption to a point where the new budget line is tangent to the old Indifference curve. This point represents a situation where there is less present consumption, and more future consumption. The Income Effect then can be illustrated by the move from S to any point on the New Budget Line between A & B because both are normal goods. What is important to note is that this includes bundles that include more present consumption (and therefore less saving) than at CPe. Both the income and substitution effects are indeed pushing the household to increase future consumption (because interest rate increases means that \$1 is worth more future income than before), so it is positive that that increases. However, the two effects are working against each other as the Substitution effect pushes toward less present consumption, and the Income Effect pushes toward more
present consumption. This means that without actual numbers, we cannot be sure whether present consumption (and thus saving supply) will rise or fall when the interest rate increases. It is very possible that the household could move to a point where it has more money in the future, but it still saving the same amount of its income (ex. Point B on the graph, which is the minimum point it could move to) – the same amount of money would just be worth more in the future because of the higher interest rate.

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