Suppose that the real interest rate climbs. In that case,
A) the income effect pushes consumption in the first year up in opposition to the substitution effect that pushes down first-year consumption.
B) the income effect pushes consumption up in the second year and is supported by a second push generated in year 2 by the substitution effect.
C) it would be impossible to tell whether consumption increases or decreases in year 1 because the income and substitution effects push in opposite directions.
D) the substitution effect tends to depress current consumption because future consumption becomes less expensive.
E) all of the above.

Question

Quizplus · Accepted Answer

When the real interest rate increases, the income effect and the substitution effect influence consumption in different ways. The income effect might push consumption up because individuals feel wealthier (if they are net savers), while the substitution effect tends to depress current consumption because saving becomes more attractive (future consumption becomes less expensive). Both A and D describe these opposing forces accurately for the first year. B correctly states that in the second year, both effects push consumption up, as higher interest rates make future consumption more attractive, assuming individuals have saved more in the first year. C correctly notes the ambiguity in the net effect on consumption in the first year due to these opposing forces. Therefore, all statements A, B, C, and D are correct in their descriptions of the effects of a rise in the real interest rate on consumption, making E the correct choice.

Suppose That the Real Interest Rate Climbs