If an increase in the interest rate raises savings, then
A)the substitution effect is greater than the income effect.
B)the income effect is greater than the substitution effect.
C)the income effect and the substitution effect move in the same direction.
D)we are unable to determine the sizes of the income and substitution effects without more information.

Question

Quizplus · Accepted Answer

An increase in interest rates raises the opportunity cost of spending, since higher interest rates make it more attractive to save than to spend. This suggests a substitution effect, where people switch their spending from consumption to saving. The income effect, on the other hand, suggests that an increase in interest rates raises the opportunity cost of leisure, since the return from saving is now higher. However, in this case, it is likely that the substitution effect dominates, since people have a limited amount of leisure time and are unlikely to work more simply because the return from saving has increased. Therefore, the best answer is A, where the substitution effect is greater than the income effect.

If an Increase in the Interest Rate Raises Savings, Then