When real interest rates rise, consumption will shift:
A)only if income rises as well.
B)downward if the income effect outweighs the substitution effect.
C)downward if the substitution effect outweighs the income effect.
D)downward if there is saving.

Question

Quizplus · Accepted Answer

When real interest rates rise, the cost of borrowing increases, which leads to a decrease in consumption expenditure. This occurs due to the substitution effect, as the cost of borrowing has increased relative to the cost of saving, making saving more attractive than spending.

The income effect may also play a role, as higher interest rates may reduce the disposable income available for spending, by increasing the cost of servicing existing debt obligations. However, the magnitude of the income effect depends on the level of income and the proportion of income spent on debt servicing, and may not always outweigh the substitution effect.

Therefore, consumption will shift downward if the substitution effect outweighs the income effect, as stated in choice C.

When Real Interest Rates Rise, Consumption Will Shift