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Describe the effect of an increase in the real interest rate on current and future consumption...

Describe the effect of an increase in the real interest rate on current and future consumption for a borrower in the two period model. Explain using the Substitution Effect and the Income Effect.

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A rise in the real interest rate in the market reduces the relative price of future consumption goods in regard to the current consumption products, thus causes to both income and substitution effects. A rise in the real interest rate causes a rise in future consumption for lender while current consumption decreases for a borrower. In the enclosed graph-1 an increase in the real interest rate causes substitution effect for lender by moving from A to D and income effect for lender by moving from D to B. In the enclosed graph-2 for a borrower the substitution effect is from moving from A to D and income effect by moving from D to B

Future Consumption we (1 +11) wez(1 + r) Current Consumption For Lender Graph-1 wewe Future Consumption we (1+1) wez(1+) We2

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