Use the intertemporal budget constraint — equation (2 ) — to explain how an increase in the real interest rate causes two distinct effects, an income effect and a substitution effect,

Question

and how those effects differ depending on whether the consumer is a saver or a borrower.

Answer 1

An increase in the real interest rate affects the first term on the RHS. For savers, the term is positive: the higher interest rate increases the value of lifetime resources, enabling more consumption in either period. For borrowers, the term is negative, so the higher interest rate reduces the value of lifetime resources. This is the income effect. For both savers and borrowers, the higher interest rate (because it is multiplied by ) makes current consumption relatively more expensive compared to future consumption. That is, reducing current consumption by one unit at the higher interest rate enables a larger increase in future consumption than at a lower interest rate. This is the substitution effect.