Question

1 Assume the same setup as in problems 1 and 2, except that we now won’t assume that β = 1+r . Again, start with a graphical representation Jeff’s optimal choice (using some arbitrary choices for his income (y1, y2), β, and r). Please answer the following questions:

(a) How would Jeff’s budget set change if the interest rate on borrowing rb was now higher than the interest rate on lending rl. You only need to analyze this graphically. There is no need to do any algebra.

(b) Give an example in which this change would affect Jeff’s choices. Explain why.

Answer 1

line o get to be the interest rate on borrowing & re be the . Interest rate on saving. . given : r >re note: the slope of the budget the ir (1+r) when. slope of budget line is -(1+r) when borrowing. 1 tl tv, 11. > Hit?? : : budget line is steeper when borrowing (consumption Caa. suving 1 C2 RA period 2 / . (Pula) a (consumption in penod 1) : ABC new badget line ; ABD old budget line: The points lying on ABC & inside the shaded region is budget set The situation in which it will impacts the jest choices is that it he was a borrower before the increase in interest rate on borrowing and if he continues to remain borrower he will be worse off Incin earlier. So, he should switch to becoming a saver if the - interest rate in borrowing increases ..