Because changes in interest rates produce substitution and income effects that ________, we can't be sure what happens to _______ if interest rates change.

Question

Quizplus · Accepted Answer

Changes in interest rates have both substitution and income effects. The substitution effect is related to the opportunity cost of saving, and as interest rates increase, the cost of saving increases, and people tend to save more. However, the income effect is related to changes in purchasing power, and as interest rates increase, the cost of borrowing increases, which reduces disposable income and decreases consumption. The income and substitution effects pull in opposite directions for saving. Therefore, we can't be sure what happens to saving if interest rates change.

Because Changes in Interest Rates Produce Substitution and Income Effects