Consider the budget constraint between "spending today" on the horizontal axis and "spending a year from today" on the vertical axis. Suppose that you have $100 today and expect to receive $100 one year from today. Your money market account pays an annual interest rate of 25%, and you may borrow money at that interest rate. Suppose now that the interest rate increases to 40%. What happens to the slope of your budget constraint relative to when the interest rate was 25%? The slope
A)becomes steeper.
B)becomes flatter.
C)doesn't change because the budget constraint shifts in parallel to the original budget constraint.
D)doesn't change because the budget constraint shifts out parallel to the original budget constraint.

Question

Quizplus · Accepted Answer

When the interest rate increases to 40%, the opportunity cost of spending today increases, making the slope of the budget constraint steeper. This is because the amount that can be borrowed at 40% interest is less than the amount that can be borrowed at 25% interest, so there is less cushion for current spending before hitting the borrowing constraint.

Consider the Budget Constraint Between "Spending Today" on the Horizontal