Suppose Reta is planning for retirement in a two-period world. In the first period Reta is young and earns $1 million, and in the second period Reta is old and retired and earns nothing. The interest rate is initially 10 percent, but then it falls to 7 percent. After the interest rate falls, the
A)substitution effect will induce Reta to consume more when she is young.
B)substitution effect will induce Reta to consume less when she is young.
C)income effect will induce Reta to consume more when she is young.
D)change in interest rates affects the substitution effect but not the income effect.

Question

Quizplus · Accepted Answer

The substitution effect will induce Reta to consume more when she is young because the lower interest rate makes it cheaper to borrow money to finance consumption in the first period.

Suppose Reta Is Planning for Retirement in a Two-Period World