Change in the Rates of Interest Analysis - Essay Example

Indifference curves are used to represent the potential patterns in demand conditions for the bundles of goods of the individual consumers. The study concerning the relative value to two or more payoffs over different periods of time but assigned by the consumers is regarded as intertemporal choice. In the model it is assumed that the consumer lives for two periods. The consumption in the first and second period is denoted by c1 and c2 respectively. The income levels in the same periods are denoted by y1 and y2 respectively and both are greater than zero. The households have the potential to save some portion of his income in the first period or borrow against the future income. The savings and the interest rates on savings or the loan is denoted by s and r respectively. Therefore the budget constraint in the first period is c1+s=y1+A, while the budget constraint in the second period is denoted by c2=y2 + (1+r) s. A represents the initial wealth.

Summing up the two constraints the following equation is obtained.

According to income effect, in the case of a saver, the income rises due to the rise in the rate of interest for a certain amount of savings. Therefore the amount of consumption rises in both periods. But for a borrower the income effect is negative for consumption in both periods. According to substitution effect the gross rate of interest (1+r) is relative to the consumption price in the first period to consumption in the next period.  Therefore consumption in the first period becomes more expensive relative to that of next period. So, consumption in next period increases while consumption in the initial period decreases. It can be deduced that an increase in the rate of interest for a saver increases the consumption in the next period and may increase or decrease the amount of consumption in the initial period. The case is just the opposite for a borrower. The following diagram shows the indifference curve for a consumer who is a lender.

The diagram below shows the indifference curve for the consumer who is a borrower.

The following diagram shows the indifference curves after an increase in current income: The case of lender

The budget of Ophelia between the current and the future income is kinked at the point where the consumption levels are equal to the level of income for each period. The highest indifference curve that can be achieved by the person with the affordable budget touches the kink. The extensions of the lines pass above the indifference curve and meet the kink. The lines represent the points where the person could have moved if she could have borrowed at the same rate as lending and lend at the rate of borrowing respectively (University of Minnesota, n.d).