In Class we considered the case in which the consumer can borrow and lend freely and the interest rate r. We also considered the case in which the individual can save at rate r but cannot borrow at all. Consider now the intermediate case in which the interest rate charged by the bank for borrowing is larger than the interest rate paid by the bank to the consumer for the money they deposit in the bank. In other words, the consumer can SAVE at the rate rs (s for saving) and can BORROW at rate ro (b for borrowing) with rb > rs. The individual receives y1 and y2 in periods 1 and 2 respectively.

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Chapter13: Monetary Policy: Conventional And Unconventional
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2 Different Rates for Borrowing and Lending
In Class we considered the case in which the consumer can borrow and lend freely and the interest rate r. We also
considered the case in which the individual can save at rate r but cannot borrow at all.
Consider now the intermediate case in which the interest rate charged by the bank for borrowing is larger than the
interest rate paid by the bank to the consumer for the money they deposit in the bank. In other words, the consumer can
SAVE at the rate rs (s for saving) and can BORROW at rate rp (b for borrowing) with rp > rs. The individual receives y1
and y2 in periods 1 and 2 respectively.
(i) Graph the budget constraint for the individual.
(ii) Add to your graph the consumer's indifference curves. Show graphically three possible outcomes: one in which
the consumer saves, one in which he borrows, and one in which he neither borrows nor saves.
• (iii) Consider the case in which he SAVES. How does consumption in period 1 change when the interest rate rb
increases a little bit? How does consumption in period 1 change when the interest rate rs increases a little bit?
• (iv) Consider now the case in which he BORROWS. How does consumption in period 1 change when the interest
rate rp increases a little bit? How does consumption in period 1 change when the interest rate rs increases a little
bit?
• (v) Finally, consider the case in which he does NOT BORROW OR SAVE. How does consumption in period 1
change when the interest rate rp increases a little bit? How does consumption in period 1 change when the interest
rate rs increases a little bit?
Transcribed Image Text:2 Different Rates for Borrowing and Lending In Class we considered the case in which the consumer can borrow and lend freely and the interest rate r. We also considered the case in which the individual can save at rate r but cannot borrow at all. Consider now the intermediate case in which the interest rate charged by the bank for borrowing is larger than the interest rate paid by the bank to the consumer for the money they deposit in the bank. In other words, the consumer can SAVE at the rate rs (s for saving) and can BORROW at rate rp (b for borrowing) with rp > rs. The individual receives y1 and y2 in periods 1 and 2 respectively. (i) Graph the budget constraint for the individual. (ii) Add to your graph the consumer's indifference curves. Show graphically three possible outcomes: one in which the consumer saves, one in which he borrows, and one in which he neither borrows nor saves. • (iii) Consider the case in which he SAVES. How does consumption in period 1 change when the interest rate rb increases a little bit? How does consumption in period 1 change when the interest rate rs increases a little bit? • (iv) Consider now the case in which he BORROWS. How does consumption in period 1 change when the interest rate rp increases a little bit? How does consumption in period 1 change when the interest rate rs increases a little bit? • (v) Finally, consider the case in which he does NOT BORROW OR SAVE. How does consumption in period 1 change when the interest rate rp increases a little bit? How does consumption in period 1 change when the interest rate rs increases a little bit?
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