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.Consider the budget constraint between “spending today” on the horizontal axis and “spending a year from today” on the vertical axis. What is the slope of this budget constraint?
The interest rate of the money market account is 25%. Money can also be borrowed from the account at the same rate. You have $100 right now and are going to receive $100 after one year.
Consider the two extreme cases, in the first you do not spend anything today and save all the money you have to be spent after one year. The amount available with you after one year would be 100 + 100*(1 + 0.25) = 100 + 125 = $225.
On the other hand if you decide to spend everything today, you could borrow an amount today that would be equal to $100 after 1 year so that it can be repaid back when you receive the $100. The total money with you in this case would be 100 + 100/1.25 = 100 + 80 = 180.
The horizontal axis represents the amount spent today and the vertical axis represents the amount spent after one year. The points available are (180, 0) and (0, 225). This gives the slope of the line as `(225 - 0)/(0 - 180)` = `-225/180` = `-1.25`
The slope of the budget constraint is -1.25.