EC201: Microeconomic Principles I

1.6 Saving and borrowing

Savings and borrowing

• What determines the borrowing and saving behaviour of

individuals?

• These are intertemporal decisions - they involve a trade off

between current and future consumption

• How do income and interest rate changes affect saving and

borrowing?

2
Savings and borrowing

1. The time value of money and present discounted value

2. Model assumptions
3. The intertemporal budget constraint
4. Saving and borrowing decisions
5. Effects of an interest rate increase
6. Different borrowing and lending rates

3
1. The time value of money

• What would you prefer: £1000 today or £1000 in one year’s time?

• £1000 today is not the same as £1000 received in future

Today Next year

Invest £1000 +
£1000 (saving in interest
bank/bond)

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1. The time value of money

• Let 𝑟 denote the interest rate

Today Next year

£1000 £1000(1 + 𝑟)

Present value Future value

• 𝐼𝑓 𝑟 = 5% = 0.05, then £1000 today is equivalent to £1050 in a year

5
1. The time value of money

• What is the present value of £1000?

Present value Future value

£? £1000

• Discounting is the process of converting FV into PV

• Divide by (1 + 𝑟) to discount back by one time period

Present value Future value

£1000/(1+r) £1000
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1. The time value of money

• In general:
Present value Future value
𝑦
(1 + 𝑟) 𝑦

£"
• is the ‘price’ of one extra unit of consumption in the next time period -
("$%)
what you must save today to have £1 more next period

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Present discounted value

• Consider an income stream over a series of dates 𝑡 = 0,1,2, … 𝑇

𝑦' , 𝑦" , 𝑦( , … 𝑦) … 𝑦*

• The present discounted value at date 0 of this income stream, discounted at

an interest rate 𝑟, is:

"! "" "# "$

𝑦! + + " +⋯ # +⋯
#$% #$% #$% #$% $

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Present discounted value
• The present discounted value of lifetime wealth:
+! +" +# +$
𝑦' + "$%
+ "$% "
+⋯ "$% #
+⋯ "$% $

• Saving or borrowing allows consumption be less or more than income at 𝑡

• The present discounted value of lifetime consumption:

,! ," ,# ,$
𝑐' + "$%
+ "$% "
+⋯ "$% #
+⋯ "$% $

• The two must be equal in order to have no residual savings or debt at 𝑇

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2. Model assumptions
• Let there be two time periods: 0 (present) and 1 (future)

• Income in these two periods: 𝑦' and 𝑦"

• Saving and borrowing is possible at interest rate 𝑟

• The consumer derives utility from consumption in the two periods, with
preferences described 𝑢 𝑐' , 𝑐"

• The consumer chooses 𝑐' and 𝑐" to maximise utility subject to an

intertemporal budget constraint and non-negativity constraints

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Assume perfect capital markets
This is a strong assumption which implies:
1. No uncertainty
2. Can borrow and lend at the same interest rate 𝑟
3. The only constraint on borrowing is that the consumer has enough
income to repay debt
4. There is a perfect and costless mechanism that ensures no one takes on
loans that they cannot repay and that all debts are repaid

How plausible are these assumptions?

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3. The intertemporal budget constraint
• Consider each time period:

• Period 0: savings 𝑠' = 𝑦' − 𝑐' > 0 (or borrowing if < 0)

• Period 1: dissaving 𝑐" = 𝑦" + 1 + 𝑟 𝑠' (or repaying debt)

• Combining: 𝑐" = 𝑦" + 1 + 𝑟 𝑦' − 𝑐'

• Rearranging: 𝑐" = 𝑦" + 1 + 𝑟 𝑦' − 1 + 𝑟 𝑐'

• Straight line intertemporal budget constraint with gradient − 1 + 𝑟

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3. The intertemporal budget constraint
𝑐"
𝑐" = 𝑦" + 1 + 𝑟 𝑦' − 1 + 𝑟 𝑐'
𝑦! + 1 + 𝑟 𝑦"
Gradient: − 1 + 𝑟
Saving
Endowment: 𝑦' , 𝑦"

𝑦! ● Borrowing

0 𝑦! 𝑐'
𝑦" 𝑦" +
1+𝑟
13
3. The intertemporal budget constraint
• Lets have a closer look at the budget constraint

• It can be expressed in future value terms:

𝑐" + 𝑐' 1 + 𝑟 = 𝑦" + 𝑦' 1 + 𝑟

• Or in present value terms:

𝑐" 𝑦"
𝑐' + = 𝑦' +
1+𝑟 1+𝑟

14
4. Saving and borrowing decisions
• Assume consumer preferences satisfy completeness, transitivity and
continuity so can be represented by a utility function 𝑢 𝑐' , 𝑐"

• The consumer chooses 𝑐' and 𝑐" to maximise 𝑢 𝑐' , 𝑐" subject to:
1. The intertemporal budget constraint: 𝑐! = 𝑦! + 1 + 𝑟 𝑦" − 1 + 𝑟 𝑐"
2. Non-negativity constraints 𝑐' ≥ 0, 𝑐" ≥ 0

• Assume non-satiation and convexity assumptions are satisfied - indifference

curves are downward sloping and convex to the origin.
• What exactly does non-satiation mean here? See Appendix
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Optimal consumption
𝑐"
Endowment: 𝑦' , 𝑦"
𝑦! + 1 + 𝑟 𝑦" Utility maximised where:
𝑀𝑅𝑆 = 1 + 𝑟

𝑦! ● Borrowing household

𝑐! ●

0 𝑦! 𝑐'
𝑦" 𝑐" 𝑦" +
1+𝑟
16
Optimal consumption
𝑐"
Endowment: 𝑦' , 𝑦"
𝑦! + 1 + 𝑟 𝑦" Utility maximised where:
𝑐! ● 𝑀𝑅𝑆 = 1 + 𝑟

𝑦! ● Saving household

0 𝑐" 𝑦! 𝑐'
𝑦" 𝑦" +
1+𝑟
17
5. Effects of an interest rate increase

• Suppose the interest rate rises from 𝑟𝐴 to 𝑟𝐵

Key result: an interest rate increase

• never makes a saver worse off
• usually makes a borrower worse off

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5. Effects of an interest rate increase
𝑐" • The interest rate rises from 𝑟𝐴 to 𝑟𝐵
− 1 + 𝑟$

• The budget line pivots around the

endowment point (why?)

𝑦! ●
Endowment
• New budget line is steeper

− 1 + 𝑟#
0
𝑦" 𝑐' 19
Borrower
𝑐" • Any household that borrows before
− 1 + 𝑟$
and after the rate increase is worse
off after the rate increase

𝑦! ●

● 𝐵 ●𝐴
− 1 + 𝑟#
0
𝑦" 𝑐' 20
Borrower: income and substitution effect
𝑐" • Substitution effect: A to D
− 1 + 𝑟$
• Income effect: D to B

𝑦! ●
●𝐷
● 𝐵 ●𝐴
− 1 + 𝑟#
0
𝑦" 𝑐' 21
Borrower: income and substitution effect
𝑐" Substitution effect: A to D
− 1 + 𝑟$ • Borrowing more expensive so reduces
𝑐' and increases 𝑐(
• negative effect on 𝑐'

Income effect: D to B
𝑦! ● • Borrowing more expensive so poorer
●𝐷
• reduces 𝑐' and 𝑐( if normal
● 𝐵 ●𝐴 • negative effect on 𝑐'
− 1 + 𝑟#
0 • Both effects decrease borrowing
𝑦" 𝑐' 22
Saver
𝑐" • Any household that saves before
− 1 + 𝑟$
the rate increase is better off after
the rate increase
●𝐵

● • 𝐴 lies within the new budget line –

𝐴
the household could continue to
𝑦! ● consume at 𝐴 after the rate change,
so cannot be worse off

− 1 + 𝑟#
0
𝑦" 𝑐' 23
Saver: income and substitution effect
Substitution effect: A to D
𝑐" • Saving more rewarding so increases
− 1 + 𝑟$ saving
●𝐵 • negative effect on 𝑐'
●
𝐷 ●
𝐴 Income effect: D to B
𝑦! ●
• Saving more rewarding so richer
• raises 𝑐' and 𝑐( if normal
• positive effect on 𝑐'

− 1 + 𝑟#
Ambiguous effect on saving
0
𝑦" 𝑐' 24
Borrower could become a saver!
𝑐" • Household that switches from
− 1 + 𝑟$
borrowing to saving is better off
after the rate change
●𝐵
• Income and substitution effects as
𝑦! in saver case
●
𝐴

− 1 + 𝑟#

0
𝑦" 𝑐' 25
6. Different borrowing and lending rates
• So far we have assumed the borrowing and lending rates are equal

• But banks profit from the difference between the rate at which they borrow
and the rate at which they lend or invest their money

• Also, if some borrowers default then banks must charge a higher interest
rate so as not to make losses overall

• So in general 𝑟- > 𝑟.

• Banks might also impose credit limits; in 2008 banks were unwilling to lend
to each other, due to worries about default due to bank failure
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6. Different borrowing and lending rates
𝑐"
• Kinked budget line
− 1 + 𝑟& • Borrowing segment with slope
− 1 + 𝑟-
𝑦!
• Saving segment with slope
− 1 + 𝑟.
− 1 + 𝑟%

0
𝑦" 𝑐' 27
6. Different borrowing and lending rates
𝑐"
Borrower
− 1 + 𝑟&

𝑦!

●
− 1 + 𝑟%

0
𝑦" 𝑐' 28
6. Different borrowing and lending rates
𝑐"
Saver
− 1 + 𝑟&
●
𝑦!

− 1 + 𝑟%

0
𝑦" 𝑐' 29
6. Different borrowing and lending rates
𝑐"
Neither borrow nor save
− 1 + 𝑟& • Many households would
optimise at the kink
𝑦! ●

− 1 + 𝑟%

0
𝑦" 𝑐' 30
Let’s add a credit limit
𝑐"
• Borrowing limited
− 1 + 𝑟& • If the credit limit binds, then the
borrower is worse off
𝑦! ● − 1+𝑟
%

●
●

0
𝑦" 𝑐' 31
What have we achieved?

• Explained why present discounted value can be used to value income

streams

• Examined a simple model of borrowing and saving

• Found ambiguous effects of interest changes on saving

• Explored effects of different borrowing and lending rates and credit

limits

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 Appendix:
A closer look at non-satiation in this model
Non-satiation
• The consumer chooses the income stream with the highest present value
• Consider:
𝑐"
• Income stream A: 𝑦') , 𝑦()
• Income stream B: 𝑦'* , 𝑦(*
● 𝑦"# , 𝑦!#

• A has the highest present value! 𝑦"$ , 𝑦!$ ●

0 𝑦!$ 𝑦!# 𝑐'

𝑦"$ + 𝑦"# +
1+𝑟 1+𝑟 34
Non-satiation
• Which is preferred depends on the interest rate!
• Low 𝑟 prefer A 𝑐"
• High 𝑟 prefer B
Gradient: − 1 + 𝑟
𝐴●

●𝐵

0 𝑐'