Final answer:
Intertemporal substitution (IS) is about how individuals make choices between present and future consumption and leisure, affected by interest rates. An increase in interest rates leads to a substitution effect favoring future consumption and an income effect that potentially increases both present and future consumption.
Step-by-step explanation:
The concept of intertemporal substitution (IS) pertains to the tradeoffs households make between consumption and leisure over time. The indifference curve in this context displays the combinations of leisure and consumption at different periods that deliver the same utility to an individual.
In the labor-leisure choice, for instance, these curves show how leisure time and income can be traded off to maintain a certain satisfaction level. Similarly, in an intertemporal choice, they demonstrate the possible combinations of present and future consumption that yield the same utility. An interest rate change gives rise to both substitution and income effects on consumption choices.
When the interest rate increases, the substitution effect typically leads to more future consumption because the cost of earning future income has decreased, making it more attractive to save and consume later.
This is a result of the opportunity cost of current consumption increasing since present expenses have a higher future value due to the rate hike. Conversely, the income effect of an interest rate rise causes individuals to increase both present and future consumption if they view them as normal goods.
This is because higher interest rates can effectively increase one's wealth, allowing for increased consumption in both periods. When interest rates decrease, the directions of these effects are reversed, and the preference for present consumption typically increases.