 QUESTION

# Hi, need to submit a 1000 words essay on the topic Using a two-period model of inter temporal consumer choice explain the effects of an increase in the interest rate on the level of consumption in eac

Hi, need to submit a 1000 words essay on the topic Using a two-period model of inter temporal consumer choice explain the effects of an increase in the interest rate on the level of consumption in each period and on whether the consumer has become better off when the consumer is: (a) a borrower in th.

A number of assumptions have to be considered before providing an analysis of the inter-temporal choices of the consumers. 2 periods of time have been taken into consideration in the entire lifetime of an individual. The income that the person earns in the first period is Y1 while that is earned in the period 2 is Y2. On the other hand the consumption level of the consumers in period 1 and 2 are C1 and C2 respectively. The rate of interest or the cost of capital at the present period is r. This is the present rate at which the consumer can either lend or borrow a sum of money.

The individuals have a choice in this context. They can either save some of the income in the present period for use in the future period consumption. Alternatively he can borrow and consume in the present period and repay the borrowed amount in the future period. Thus in each period of time he would have some income to spend.

In the first case it has been assumed that the consumer decides to borrow. In this case the consumption of period 1 would be more than the consumption in period 2. This would be true is C1&gt.Y1. Thus in the second period he has to pay an interest of amount r (C1-Y1) along with the principle amount of (C1-Y1) which he had borrowed in period 1. In such case the budget constraint of the consumer would be

Thus the positivity or negativity of the term (Y1 - C1) determined whether the individual is a saver or a borrower in period 1. Alternatively the consumer can save more and consume less in period 1. He would earn an interest on his savings and therefore his consumption in period 2 would be more (Varian, 2010, pp. 183-202).

The interest is thus the opportunity cost that the lender earns or the borrower pays for either giving up the use of the money at the future period or the possibility of the use of the funds at the present period. It is the value