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Select Topics in Macroeconomics – 2013
Questions and Answers
Section A
Question 1
The household budget constraint is:
w
C w L𝑃
C + =𝐵 + L +
1+𝑖 𝑃 1+𝑖
This simply states that the household’s discounted total consumption (which is the sum of their
consumption on goods and services) is equal to their total income (which is their labour income and
their initial bond position).
Now, when considering an increase in the real interest rate, r, there are two effects which must be
considered; the income and substitution effect. The graph below shows the change in household’s
budget constraint as the interest rate, r, increases. The slope of the LBC decreases, and the
intercepts change.
If the household is a saver, then before the increase in the interest rate their optimum consumption
bundle is where c1 > y1, and c2 < y2. This is shown by the red dot below.
We can decompose the change in the interest rate into two separate effects. First is the substitution
effect. This is shown in the graph below by the “pivot” of the budget curve around the same
indifference curve. Intuitively, the consumer substitutes away from current consumption (c1) and
substitutes towards future consumption (c2). Because the interest rate has increased, it has become
relatively more expensive to consume in the current period as compared to future periods. This is
because the household could save money and receive more interest on it. The substitution effect is
shown by the shift from the red dot to the green dot.
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
Select Topics in Macroeconomics – 2013
Questions and Answers
Section A
Question 1
The household budget constraint is:
w
C w L𝑃
C + =𝐵 + L +
1+𝑖 𝑃 1+𝑖
This simply states that the household’s discounted total consumption (which is the sum of their
consumption on goods and services) is equal to their total income (which is their labour income and
their initial bond position).
Now, when considering an increase in the real interest rate, r, there are two effects which must be
considered; the income and substitution effect. The graph below shows the change in household’s
budget constraint as the interest rate, r, increases. The slope of the LBC decreases, and the
intercepts change.
If the household is a saver, then before the increase in the interest rate their optimum consumption
bundle is where c1 > y1, and c2 < y2. This is shown by the red dot below.
We can decompose the change in the interest rate into two separate effects. First is the substitution
effect. This is shown in the graph below by the “pivot” of the budget curve around the same
indifference curve. Intuitively, the consumer substitutes away from current consumption (c1) and
substitutes towards future consumption (c2). Because the interest rate has increased, it has become
relatively more expensive to consume in the current period as compared to future periods. This is
because the household could save money and receive more interest on it. The substitution effect is
shown by the shift from the red dot to the green dot.
