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. A consumer receives his income in two periods, can save or borrow, and views a...

. A consumer receives his income in two periods, can save or borrow, and views a unit of consumption in period 1 as a perfect substitute (one for one) for a unit of consumption in period 2. If the nominal interest rate is 5% and the inflation rate is 6%, the consumer will: a. Consume only in period 1. b. Consume only in period 2. c. Consume equal amounts in each period. d. Consume more in period 1 than in period 2 if income elasticity exceeds 1. e. Equalize expenditures but not consumption in the two periods.

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Answer #1

Answer - a (Will consume only in period 1)

The real interest rate is negative. So, since his consumption in period 1 and 2 are perfect substitutes, he will consume only in Period 1.

Example- assume his income is 10 units in both periods. For simplicity, let the price of goods be 1 unit in period 1. Then the price will be 1.06 in period 2. With his income in period 2, he will be able to buy only (10/1.06) goods in period 2. On the other hand, he can borrow (10/1.05) in period 1 and he will have to pay 10 back (including the interest). With this borrowed amount, he can buy (10/1.05) goods in period 1 which more than (10/1.06).

Hence, he will borrow and spend in period 1.

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