Answer to Question #96734 in Microeconomics for Nav Chatwal

Question #96734

Suppose that a person can borrow and lend at an interest rate of 10 per cent. But there is a 5% rate of inflation and one has to pay an income tax of 30 % on all interest income. If you borrow money, you can deduct interest as an expense. Where current consumption is on the horizontal axis and future consumption is on the vertical axis:

(a) the budget line will have a kink at the point of no saving or lending.

(b) the budget line will be a straight line with a slope of about -1.02.

(c) the budget line will be a straight line with a slope of about -1.05.

(d) the budget line will be a straight line with a slope of about -1.35.

(e) None of the above

Expert's answer

In this case the real interest rate will be (10 - 5)×(1 - 0.3) = 3.5%. So, the budget line will be a straight line with a slope of about -1.35.

The correct answer is d.