Consider Sally and Bob. They both live for two periods and have the same stream

Question

Consider Sally and Bob. They both live for two periods and have the same stream of income, Y1 in the first period and Y2 in the second period. However, given their different preferences for current and future consumption, at the market interest rate r, Sally saves part of her first period income for consumption in the second period and Bob borrows during the first period. If the interest rate were higher, how would Sally and Bob each adjust their current consumption, future consumption, and amount of saving or borrowing in the first period? You may assume that consumption in each period is a normal good for both consumers. Does the higher interest rate make them better off or worse off?

Explanation / Answer

In this question Both Sally and Bob are of same stream of income.But depending upon their current and future consuption, Savi saves part of First income period which means she saves her money and get interest on it which is higher. It will make Save postion Better. On the other hand BOB has borrowed money which means he has to paid higher interest on it which means he has less amount to consume in future than Savy. Which makes BOBs situation worse off.

Saly consumes less in current period as she saved In YI

Bob consumed More than his income as he borrowed money in Y1.

Saving is positive when a person consume less than his income. On the other hand Saving is negative, when a person consumes more than his income. Eg: By Borrowing money

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