Assignment 3

Question 3
Ernie’s Borrowings
• Ernie lives for two periods, and earns m1 in period 1 and m2 in period 2. To start
with, the interest rate is r0. The budget line on this graph reflects r0 and his income
endowment.
• Let’s call the present value of endowment when the interest rate is r0 and call the
present value of endowment when the interest rate is r1 .
• This is the starting point for question parts (a), (b), and (c).
• However, before starting the question, let’s look at how we can think about the
fall in the interest rate: r1<r0.
c2

m2

f(r0, )
m1 c1
• We know that, when the interest rate is r1, Ernie will end up on the budget
constraint that reflects r1 and his endowment m1 and m2. That is the line f(r1, )
below.
• Note that the interest rate appears in the numerator of the slope of a budget
constraint, so a lower interest rate means a flatter line.
• This is the same for all three parts of the question.
c2

m2

f(r0, ) f(r1, )
m1 c1
• During the exercise, we will construct two kinds of hypothetical budget constraints, both
have the slope that reflects the new interest rate.
• The budget line that has the new slope but goes through the original consumption point, and
so reflects the amount of money Ernie would need if he wanted to exactly afford his old
consumption bundle at the new slope. We call this budget line f(r 1, m’). The location of this line
depends on the original consumption point, so it will vary in each of parts (a), (b), and (c), and is
not shown here.
• The budget line that has the new slope but reflects the amount of money that the consumer
would have in present value terms if he had cashed in his endowment at the old prices. This
income does not depend on the original consumption point, but pivots around the x-axis
intercept as shown in line f(r1, m’’). This will be the same for question parts (a), (b), and (c).
c2

m2

f(r0, )
f(r1, m’’) f(r1, )
m1 c1
• In terms of algebra, we are interested in the following decomposition in each part of the
question:
c1(r1, ) – c1(r0, )

• We will decompose this change into three parts:

• c1(r1,m’) – c1(r0, ). This is the part that takes us on the budget line that varies by
question part because it reflects consumption at the new prices if we have the income
m’ that just allows Ernie to buy the old bundle. This is the only part of the
decomposition where the interest rate changes, from now on, we are at r 1.
• c1(r1,m’’) – c1(r1,m’). This is the ordinary income effect. m’’ is the income level Ernie
would have if the interest rate change had not affected the present value of his income
(like the problems we did before, allowing for income to come from endowments that
had market value).
• c1(r1, ) – c1(r1,m’’). The income endowment effect. This comes from adding in the idea
that the present value of the endowment varies with the interest rate. At the new
slope, the endowment has a present value equal to (m 1+m2/(1+r1)) which is greater
than (m1+m2/(1+r0)), since r1<r0.

• Adding up these three changes in the consumption bundle gives what we want:
c1(r1,m’) – c1(r0, ) + c1(r1,m’’) – c1(r1,m’) + c1(r1, ) – c1(r1,m’’) = c1(r1, ) – c1(r0, )
• Let’s keep the three budget constraints we already have, and turn to part (a) of the
question. This means we introduce consumption choices. Here, Ernie is a
borrower, so he might be at point A under the original prices (on f(r 0, )).

c2

f(r0, )

f(r1, m’)
m2
A
f(r1, m’’)

f(r1, )
m1 c1
• If Ernie were faced with the constraint given by f(r1, m’), which is the new
prices and hypothetical income that would allow him to consume A, he would
prefer to move to the higher indifference curve in green, and consume at B.
This is the substitution effect for part (a).

c2

f(r0, )

f(r1, m’)
m2
A
f(r1, m’’) B
f(r1, )
m1 c1
• But, he does not have the hypothetical income level m’!! He has the same endowment.
We can decompose his overall income effect into two parts, an ordinary income effect and
an income endowment effect.
• First, the ordinary income effect: This is what the income effect would be if we ignored the
fact that Ernie is coming to the market with m={m1, m2}, and pretended he came with a
lump sum of cash—the present value of the endowment at the old prices. This would put
Ernie on the budget constraint f(r1, m’’). Since both c1 and c2 are normal goods, this would
take Ernie to a consumption point like C (less of both goods compared to B).
c2
f(r0, )

f(r1, m’)
m2
A
f(r1, m’’) B
C
f(r1, )
m1 c1
• But, f(r1, m’’) is not the actual budget constraint he finds himself on after the interest
rate change!
• We know he must end up on f(r1, ), new prices and reflecting the fact that he is coming
to the market with an income stream of m={m1, m2}, which at present value terms is the
far intercept on the x-axis.
• This corresponds to a shift to a parallel budget constraint from f(r1, m’’) to f(r1, )
• Again, since both c1 and c2 are normal goods, Ernie will consume more of both. So, he
may end up at a point like D.
c2

f(r0, )

f(r1, m’)
m2
A D
f(r1, m’’) B
C
f(r1, )
m1 c1
• We note that the ordinary income effect is negative but the endowment income effect
is positive.
• We can also tell that the endowment income effect more than outweighs the negative
ordinary income effect in this part of the question. This is because the lower interest
rate allows him to borrow more to consume in period 1. The present value of his
endowment has increased.
• B reflects more c1 than at point A, and D reflects more c1 than at point B. Therefore,
point D reflects more c1 than at point A. He will borrow more! The statement in part (a)
is true!

c2 f(r0, )

f(r1, m’)
m2
A D
f(r1, m’’) B
C
f(r1, )
m1 c1
• Now for part (b) of the question. Here, Ernie is neither a saver or a borrower, so he
is at point A under the original prices (on f(r0, )).
• If Ernie were faced with the constraint given by f(r1, m’), which is the new prices
and hypothetical income that would allow him to consume A, his budget
constraint is actually the new budget constraint (because he was consuming the
endowment, and the new constraint goes through the endowment!).
• He would prefer to move to the higher indifference curve in green, and consume
at B. This is the substitution effect for this part of the question.

c2
f(r0, )

f(r1, m’) A
m2
B

f(r1, m’’)

f(r1, )
m1 c1
• Now, the ordinary income effect: This is what the income effect would be if we
ignored the fact that Ernie is coming to the market with m={m1, m2}, and
pretended he came with a lump sum of cash—the present value of the
endowment at the old prices. This would put Ernie on the budget constraint f(r 1,
m’’). Since both c1 and c2 are normal goods, this would take Ernie to a
consumption point like C (less of both goods compared to B).
c2

f(r0, )

f(r1, m’) A
m2
B

f(r1, m’’)
C
f(r1, )
m1 c1
• Finally, the endowment income effect: We know he must end up on f(r 1, ), new prices
and reflecting the fact that he is coming to the market with an income stream of
m={m1, m2}, which at present value terms is the far intercept on the x-axis.
• This corresponds to a shift to a parallel budget constraint from f(r1, m’’) to f(r1, )
• For this part of the question, f(r1, ) is equal to f(r1, m’). The two income effects cancel
each other out. Ernie ends up at point D, which is the same as point B.
• Since point B summarized the substitution effect, c1 in D is greater than c1 in A, and
Ernie starts to borrow. The statement in part (b) is true.
c2

f(r0, )

f(r1, m’) A
m2
DB
f(r1, m’’)
C
f(r1, )
m1 c1
• Now for part (c). Here, Ernie is a saver, so he is at point like A under the original
prices (on f(r0, )).

c2

m2

f(r1, m’’)
f(r0, ) f(r1, )
m1 c1
• If Ernie were faced with the constraint given by f(r1, m’), which is the new prices
and hypothetical income that would allow him to consume A, he would switch to a
point like B. This is the substitution effect for this part of the question, and leads to
less saving and more consumption in period 1.

c2

A
B
m2
f(r1, m’)

f(r1, m’’)
f(r0, ) f(r1, )
m1 c1
• But what about the income effects? In order for Ernie to save less at the new
interest rate (and maybe end up borrowing), it cannot be true that the sum of the
income effects leads him to a consumption choice that contains less c 1 than at A.
• However, it is possible that this happens.
• The ordinary income effect here is large negative, taking Ernie to the line f(r1, m’’),
say at a point like C

c2

A
B
m2
f(r1, m’)
C
f(r1, m’’)
f(r0, ) f(r1, )
m1 c1
• If the ordinary income effect has led Ernie to consume much less c1 in period 1,
then it is possible that the endowment income effect (reflecting the line f(r1, ))
does not lead to a choice that increases c1 by much.
• In this case, it could be that c1 at point D is less than c1 at point A. That is, after
the interest rate falls, Ernie saves (lends) more in period 1. That is, statement c
could be false.

c2

A
D B
m2
f(r1, m’)
C
f(r1, m’’)
f(r0, ) f(r1, )
m1 c1
THE END