Macroeconomics

F I G U R E  

1 7 - 5

Second-period 

consumption, C

2

First-period consumption, C

1

IC

2

IC

3

IC

4

IC

1

O

Budget constraint

The Consumer’s Optimum

The consumer achieves his

highest level of satisfaction

by choosing the point on the

budget constraint that is on

the highest indifference

curve. At the optimum, the

indifference curve is tangent

to the budget constraint.

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C H A P T E R   1 7

Consumption

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budget constraint is the indifference curve that just barely touches the budget

line, which is curve IC

3

in the figure. The point at which the curve and line

touch—point O, for “optimum”—is the best combination of consumption in the

two periods that the consumer can afford.

Notice that, at the optimum, the slope of the indifference curve equals the

slope of the budget line. The indifference curve is tangent to the budget line.

The slope of the indifference curve is the marginal rate of substitution MRS,

and the slope of the budget line is 1 plus the real interest rate. We conclude that

at point O

MRS

= 1 + r.

The consumer chooses consumption in the two periods such that the marginal

rate of substitution equals 1 plus the real interest rate.

How Changes in Income Affect Consumption

Now that we have seen how the consumer makes the consumption decision, let’s

examine how consumption responds to an increase in income. An increase in

either Y

1

or Y

2

shifts the budget constraint outward, as in Figure 17-6. The high-

er budget constraint allows the consumer to choose a better combination of first-

and second-period consumption—that is, the consumer can now reach a higher

indifference curve.

In Figure 17-6, the consumer responds to the shift in his budget constraint by

choosing more consumption in both periods. Although it is not implied by the

logic of the model alone, this situation is the most usual. If a consumer wants

more of a good when his or her income rises, economists call it a normal