The assumption that current-period consumption demand is negatively related to the real interest rate is justified as long as the
A)substitution effect dominates the income effect.
B)income effect dominates the substitution effect.
C)income effect and substitution effects are equal.
D)representative consumer is a lender.
E)representative consumer is a borrower.

Question

Quizplus · Accepted Answer

The negative relationship between current-period consumption demand and the real interest rate is based on the assumption that as the real interest rate increases, the opportunity cost of consuming now rather than saving and consuming in the future increases. This is the substitution effect. However, there is also an income effect, which suggests that as the interest rate increases, the income from savings also increases, which may lead individuals to consume more in the present. If the substitution effect dominates the income effect, then the negative relationship holds. If the income effect dominates, then the relationship is positive. If the income and substitution effects are equal, then the relationship is neutral. Thus, choice A, where the substitution effect dominates, is the best answer.

The Assumption That Current-Period Consumption Demand Is Negatively Related to the Real