ECON 222 Lecture Notes - Lecture 13: Real Interest Rate, Consumption Smoothing, Nominal Interest Rate

• School: Queen's University
• Department: Economics
• Course: ECON 222
• Professor: Kennedy

Document Summary

Example: suppose you receive a bonus, and mpc=0. 4. This means that current consumption will increase by (cid:4666)(cid:882). (cid:886)(cid:4667)(cid:4666)(cid:885)(cid:882)(cid:882)(cid:882)(cid:4667)=(cid:883)(cid:884)(cid:882)(cid:882) and saving will increase by (cid:885)(cid:882)(cid:882)(cid:882) (cid:883)(cid:884)(cid:882)(cid:882)=(cid:883)(cid:890)(cid:882)(cid:882): recall (cid:1853)(cid:1872) =(cid:1853)(cid:1871)(cid:1871)(cid:1872)(cid:1871) (cid:1853)(cid:1854)(cid:1872)(cid:1871) Suppose r increases: substitution effect decrease current consumption because its price (r) increases. (substitute away from consumption). Case 1: saver becomes richer because of higher payoff on savings; means that you can have the same amount of future savings with a smaller amount of current saving. Example: if future target is and r=0. 01, you need to save today to get (cid:4666)(cid:883)+. (cid:882)(cid:883)(cid:4667)(cid:4666)(cid:891)(cid:891)(cid:882)(cid:4667)=(cid:882)(cid:882)(cid:882). Suppose r increases to r=0. 05: now you only need to save . 38 in the present to get. *note that total effect is ambiguous for savers as se and ie work in the opposite direction. Increase in r makes borrower poorer since it increases interest payments, leading to a decrease in current consumption and increase in saving. Se and ie work in same direction for borrowers.