Use the concepts of income effect and substitution effect to explain why the eff
ID: 1185003 • Letter: U
Question
Use the concepts of income effect and substitution effect to explain why the effect on desired saving of an increase in the real interest rate is potentially ambiguous. Choose increase, decrease or ambiguous. When Real Interest Rate increase, Desired Saving (Lender) , Substitution Effect ,Increase/ decrease/Ambiguous Income Effect Increase/ decrease/ ambiguous Total(Net) Effect Increase/ decrease/ ambiguous When Real interest rate increase desired saving (borrower) , substitution effect increase/ decrease/ ambiguous income effect increase/ decrease/ ambiguous Total(Net) Effect Increase/ decrease/ ambiguousExplanation / Answer
a)
(1) The substitution effect increases saving, because the amount of future consumption that can be obtained in exchange for giving up a unit of current consumption rises. (2) The income effect may increase or reduce saving. The income effect reduces saving for a lender, because a person who saves is better off as a result of having a higher real interest rate, so he or she increases current consumption. However, for a borrower, the income effect increases saving, because the borrower is worse off with a higher real interest rate. So the income effect works in different directions depending on whether a person is a lender or a borrower. For a borrower, then, both the income and substitution effects work in the same direction, and saving definitely increases. For a lender, the income and substitution effects work in opposite directions, so the result on desired saving is ambiguous.
The effect on desired saving of an increase in the expected real interest rate is potentially ambiguous. An increase in the real interest rate has two effects on desired saving: (1) the substitution effect increases saving, because the amount of future consumption that can be obtained in exchange for giving up a unit of current consumption rises; and (2) the income effect may increase or reduce saving. The income effect reduces saving for a lender, because a person who saves is better off as a result of having a higher real interest rate, so he or she increases current consumption. However, for a borrower, the income effect increases saving, because the borrower is worse off having to face a higher real interest rate, and so reduces current consumption. So the income effects work in different directions depending on whether a person is a lender or a borrower. For a borrower, then, both the income and substitution effects work in the same direction, and saving definitely increases. For a lender, however, the income and substitution effects work in opposite directions, so the result on desired saving is ambiguous.
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