Suppose that the interest rate paid to those saving money increases. As a result, Chris wishes to save less. This suggests that, for Chris' new optimal level of savings, the substitution effect is greater than the income effect.

Question

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When the interest rate increases, the substitution effect encourages saving more because the opportunity cost of consuming now increases. However, if Chris wishes to save less, it suggests the income effect (feeling wealthier due to higher future returns on current savings) dominates the substitution effect, leading to increased current consumption.

Suppose That the Interest Rate Paid to Those Saving Money