When interest rates rise, the substitution effect induces savers to save more, whereas the income effect induces savers to save less.

Question

Quizplus · Accepted Answer

When interest rates rise, the substitution effect encourages savers to save more because the return on saving is higher. On the other hand, the income effect reduces the inclination to save because people feel wealthier due to the higher interest rates and therefore consume more. However, the substitution effect is stronger than the income effect in the long run, leading to an overall increase in savings.

When Interest Rates Rise, the Substitution Effect Induces Savers to Save