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1. Consumers typically pay a higher real interest rate to borrow than they receive when they lend
(by making bank deposits, for example). Draw a consumer’s budget line under the assumption
that the real interest rate earned on funds lent, r L , is lower than the real interest rate paid to
borrow, rB . Show how this consumer’s budget line is affected by an increase in the initial wealth.
I) Draw the budget line and the relevant indifference curve for a consumer who is initially a
borrower. Indicate the no-borrowing no-lending point (label it as N) and the optimal
consumption point (label it as A).
II) Show the effect of an increase in the real interest rate on the budget line and the consumer’s
optimal consumption. Using an intermediate budget line, show the income effect and the
substitution effect on the current consumption and the future consumption. Specify whether these
effects work in the same direction or the opposite directions?
3. Specify whether each statement is TRUE or FALSE. If you specify it as a FALSE statement,
then briefly explain your reason.
a) If the future income increases, then the current consumption, saving, and the future
b) The slope of the budget line depends on the real interest rate and does not depend on the level
c) There is a certain bundle of current consumption and future consumption which lies on the
budget line at any rate of interest.
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