1) Consider the two period consumption model defined by the following budget constraints:
Period 1: (1- t1) Y1=C1+s
Period 2: (1- t2) Y2 +?1+r)s= C2
Where Y is income, C is consumption, s is savings, r is the real interest rate, and t is the consumption tax rate.
A) Using the two period consumption model, show that the present value of lifetime consumption will equal the present value of after-tax lifetime income. (5pts)
B) On the graph below, show what will happen to the household’s budget line when the real interest rate r declines. (5pts)
C) Assume that the consumer is a saver and that the income effect dominates the substitution effect. What will happen to current consumption and saving when the real interest rate rises? Would your answer change if the household were a borrower? Explain. (10pts)
