Suppose Bank of England is considering using the tool of cutting interest rates to boost household consumption. In this question you will be asked to use the intertemporal choice model to assess the impact of different policies on household consumption. Suppose a consumer's current income is £25,000 and their future income is £30,000, and they initially face a market interest rate of 15% on both saving and borrowing. (d) Using the concepts of income and substitution effects, explain and illustrate in the same diagram for part (c) what impact the fall in the interest rate will have on the consumer's optimal consumption in each period. (3 marks) (e) Now suppose that the government decides to adopt a policy that reduces the interest rate on borrowing from 15% to 5%. Explain and illustrate what impact this will have on the consumer's budget constraint in the diagram you have drawn for part (a) and their optimal consumption in each period, given the available information. (3 marks)
