The Effect of Interest-Rate Changes on Consumption Allocation over Time

Abstract

TH-E INTrENTION OF TlHIS PAPER is to analyze the response of current and planned ruttire conistimption to expected increases or decreases in exogenous interest r-ates. OLlur analysis is based on examining the Slutsky equation formulation fromi the viewpoint of more than one nurmeraire. For two sets of periodsthose up to and including the earliest interest-rate change and those subsequent to the last-we show the following: The substitution effect on planned consuLMptioll is determinate in sign if the consumptions in each of these two sets of periods are not complementary to consumption in any periods outside the set itself. The sign of the income effect is generally indeterminate; it depends upon how one's lifetime constraint (and thus one's utility) is affected by the expected interest-rate changes. Based on our results, we describe an idealized experiment capable of refuting the model or, if the model is accepted as the maintained lhypothesis, capable of determining whose utility is increased or decreased by expected increases or decreases in interest rates. Our assumptions are the usual ones in the classical analysis of inter-temporal con-sumption optimization under subjective certainty [2, (115ff.)]. Non-asset income is exogenously determined, and there is subjective certainty about all the par-ameters of the model, non-asset income in every period, the planning horizon, and all present and futuLre prices, including the ex ante rates of interest. Our definitionis ar-e: