[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Budget constraint after
increase in interest rate
FUTURE CONSUMPTION
B 2
E 1
B 1
B
Initial
budget
constraint
E 2
E 0
Indifference
curves
Budget
constraint
used to trace
substitution
effect only
C 1
C
Figure 9.8
CURRENT CONSUMPTION
INCOME AND SUBSTITUTION EFFECTS OF A HIGHER INTEREST RATE
An increase in the interest rate rotates the budget constraint, moving it from BC to B 2 C.
The substitution effect describes what happens when relative prices are changed but
Maggie remains on the same indifference curve; there is a shift in the budget line from
BC to B 1 C 1 , and an increase in saving from E 0 to E 2 . The income effect is the result of an
outward shift of the budget line, keeping relative prices the same; the income effect is
described by the shift from B 1 C 1 to B 2 C, and the increase in present consumption from
E 2 to E 1 .
CHANGING THE INTEREST RATE
Indifference curves and budget constraints enable us to see the effect of an increase
in the interest rate. Figure 9.8 shows the case of an individual, Maggie, who works
while she is young and saves for her retirement. The vertical axis gives consumption
during retirement years, the horizontal axis consumption during working years. An
increase in the rate of interest rotates the budget constraint, moving it from BC to
B 2 C. It is useful to break the change down into two steps. In the first, we ask what
would have happened if the interest rate had changed but Maggie remained on the
same indifference curve. This is represented by the movement of the budget
constraint from BC to B 1 C 1 . As a result of the increased interest rate, Maggie consumes
less today—she saves more. This is the substitution effect, and it is seen in the
movement from E 0 to E 2 in the figure.
In the second step we note that since Maggie is a saver, the increased interest
rate makes her better off. To leave Maggie on the same indifference curve after the
210 ∂ CHAPTER 9 CAPITAL MARKETS