Macroeconomics

F I G U R E  

1 7 - 7

Second-period 

consumption, C

2

First-period

consumption, C

1

Y

1

Y

2

C

1

C

2

IC

2

IC

1

B

A

Initial budget

constraint

New budget

constraint

An Increase in the Interest

Rate

An increase in the inter-

est rate rotates the budget 

constraint around the point

(Y

1

, Y

2

). In this figure, the 

higher interest rate reduces

first-period consumption by

ΔC

1

and raises second-period

consumption by 

ΔC

2

.

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508

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P A R T   V I

More on the Microeconomics Behind Macroeconomics

The inability to borrow prevents current con-

sumption from exceeding current income. A con-

straint on borrowing can therefore be expressed as

C

1

≤ Y

1

.

This inequality states that consumption in period

one must be less than or equal to income in period

one. This additional constraint on the consumer is

called a borrowing constraint or, sometimes, a liq-

uidity constraint.

Figure 17-8 shows how this borrowing constraint

restricts the consumer’s set of choices. The consumer’s

choice must satisfy both the intertemporal budget

constraint and the borrowing constraint. The shaded area represents the combi-

nations of first-period consumption and second-period consumption that satisfy

both constraints.

Figure 17-9 shows how this borrowing constraint affects the consumption

decision. There are two possibilities. In panel (a), the consumer wishes to con-

sume less in period one than he earns. The borrowing constraint is not bind-

ing and, therefore, does not affect consumption. In panel (b), the consumer

would like to choose point D, where he consumes more in period one than

he earns, but the borrowing constraint prevents this outcome. The best the

consumer can do is to consume all of his first-period income, represented by

point E.

The analysis of borrowing constraints leads us to conclude that there are two

consumption functions. For some consumers, the borrowing constraint is not

“What I’d like, basically, is a temporary line of 

credit just to tide me over the rest of my life.”

Dr

awing by Handelsman; © 1985 

The New Y

o

rk

er Magazine, Inc.