The private supply of credit is an increasing function of the real interest rate if
A) the substitution effects outweighs the income effects when added across all consumers.
B) the income effects outweighs the substitution effects when added across all consumers.
C) the income effect outweighs the substitution effects for borrowers.
D) the substitution and income effects cancel each other.
E) consumers are rational.

Question

Quizplus · Accepted Answer

When the real interest rate increases, the opportunity cost of consuming today (i.e. borrowing) increases. This induces consumers to consume less today and save more for future consumption. This is the substitution effect. However, as real interest rates increase, the income from saving more also increases, which can lead to an increase in consumption today. This is the income effect. Whether the overall effect on the supply of credit is positive or negative depends on the relative magnitudes of the substitution and income effects. If the substitution effect outweighs the income effect, then the supply of credit will decrease as interest rates increase. However, if the income effect outweighs the substitution effect, then the supply of credit will increase as interest rates increase. Therefore, choice A is the best answer as it states that the substitution effects outweigh the income effects when added across all consumers, leading to an increase in the supply of credit.

The Private Supply of Credit Is an Increasing Function of the Real