Suppose you know I am only about consumption this year and consumption next year. Suppose also that I have an income this year but do not expect to have an income next year. Explain your answers. ? a. You notice that I save more after the interest rate falls. Can you tell whether "consumption now" is a normal, inferior or Giffen good? ? b. Suppose I also received an unexpected raise at work and you overhear me say: "Cool, I am even Steven. Now that I have my raise, I am just as happy as I was before the interest rate fell and I did not yet have a raise." Without knowing anything more, can you tell whether I consume more or less next year than I would have consumed had neither of the two changes happened?

Question

What will be an ideal response?

Answer 1

a. Yes, you can tell. A drop in the interest rate gives rise to a substitution effect that says consume more now. If consumption now actually falls, it means that the wealth effect pushed in the opposite direction (for a decrease in wealth from the compensated to the final budget) -- so consumption now is a normal good.b. Here, we are staying on the same indifference curve -- but the slope of the budget has become shallower. This implies a move to the right along the indifference curve -- a move to more consumption now and less consumption next year. (This is, of course, just a pure substitution effect.)