Determine how each of the following situations would affect the demand for current consumption, the supply of current consumption, and the interest rate.

Question

(i) Cuban immigrants, who own no capital of their own, arrive in the country.
(ii) A drought lowers farmers' productivity this year, but rainfall levels are expected to return to normal next year.
(iii) Scientists announce that a new lubricant that will double engine life will be available
next year.

Answer 1

(i) The immigrants' arrival will increase the demand for current consumption. Assuming labor and capital are complements in production, the increased labor raises the demand for capital and lowers the supply of current consumption. Both forces cause the interest rate to rise.
(ii) The fall in current harvests lowers the supply of current consumption. The reduction in wealth lowers the demand for current consumption, but this fall in demand will be smaller than the fall in supply (because the reduction in wealth will also lower the demand for future consumption). Consequently, the interest rate will rise.
(iii) The increased future wealth anticipated from the new lubricant will increase the demand for current consumption. The new lubricant raises the marginal value of capital, thus raising the demand for capital and lowering the supply of current consumption. Both forces cause the interest rate to rise.