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

Question

Quizplus · Accepted Answer

According to the substitution effect, an increase in the real interest rate leads to a higher opportunity cost of current consumption and therefore a decrease in consumption demand. According to the income effect, an increase in the real interest rate leads to a higher return on savings, which increases the consumer's ability to consume goods in the future, leading to an increase in consumption demand. The assumption that current-period consumption demand is negatively related to the real interest rate is justified when the substitution effect dominates the income effect. Therefore, the correct answer is B.

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