Suppose Olivia is planning for retirement in a two-period world.In the first period Olivia is young and earns $1 million,and in the second period Olivia is old and retired and earns nothing.The interest rate is initially 10 percent,but then it falls to 7 percent.Which of the following must be true?
A)After the interest rate falls, the substitution effect will induce Olivia to consume more when she is young.
B)After the interest rate falls, the substitution effect will induce Olivia to consume less when she is young.
C)After the interest rate falls, the income effect will induce Olivia to consume more when she is young.
D)After the interest rate falls, the income effect will induce Olivia to consume less when she is young.

Question

Quizplus · Accepted Answer

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

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