Final answer:
When real interest rates decrease, future consumption decreases, current consumption increases, and the no-borrowing/no-lending point decreases. This is due to the interplay of substitution and income effects that impact a consumer's preference for current over future consumption. The preferred point along an indifference curve is the one that optimizes both current and future consumption within budget constraints.
Step-by-step explanation:
When the real interest rate decreases, future consumption decreases, current consumption increases, and the no-borrowing/no-lending point decreases. The income effect implies that when real interest rates decrease, individuals feel less wealthy regarding their future income and are inclined to save less, thus consuming more in the present. However, the substitution effect would suggest that when future consumption becomes relatively more expensive (because saving earns less interest), individuals may choose to consume more in the current period instead of saving for future consumption.
The overall impact on current consumption will depend on the relative strength of these two effects. If the substitution effect is stronger than the income effect, we would expect a more significant increase in current consumption when the real interest rate falls. Conversely, if the income effect dominates, the rise in current consumption may be smaller.
Review Questions
Exercise B1: What point is preferred along an indifference curve? The preferred point along an indifference curve is the one that allows for the highest level of consumption for both current and future periods, given the consumer's budget constraint.