In the two-period model, suppose a household's income in the first period is $30,000, income in the second period is $40,000, and the real interest rate is 20 percent. Draw a diagram showing the budget constraint. Now, suppose the real interest rate rises to 25 percent. Draw the new budget constraint. For the budget constraints you have drawn, be sure to show the values of the intercepts on each axis. Show your work.
What will be an ideal response?
Initial situation: intercept for first-period consumption axis = 30,000 + 40,000/1.2 = 63,333; intercept for second-period consumption axis = 6,000 + 30,000 + 40,000 = 76,000.
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New situation: intercept for first-period consumption axis = 30,000 + 40,000/1.25 = 62,000; intercept for second-period consumption axis = 7,500 + 30,000 + 40,000 = 77,500.
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Budget constraint rotates clockwise, from AB to CD.
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