Intertemporal Budget Constraint
-Given the table above,suppose consumption in period two is $40,000.Then,the interest rate rises to five percent,and period-two consumption rises to $41,050.We may infer that ________.
A)the income effect is stronger than the substitution effect
B)the substitution effect is stronger than the income effect
C)the substitution and income effects cancel out
D)this consumer has a binding borrowing constraint

Question

Intertemporal Budget Constraint 
-Given the table above,suppose consumption in period two is $40,000.Then,the interest rate rises to five percent,and period-two consumption rises to $41,050.We may infer that ________.
A)the income effect is stronger than the substitution effect 
B)the substitution effect is stronger than the income effect 
C)the substitution and income effects cancel out 
D)this consumer has a binding borrowing constraint

Quizplus · Accepted Answer

According to the intertemporal budget constraint, an increase in the interest rate leads to a decrease in current consumption (substitution effect) and an increase in future consumption (income effect). Since period two consumption increases in this scenario, it suggests that the substitution effect (i.e. decrease in current consumption due to higher interest rates) is weaker than the income effect (i.e. increase in future consumption due to higher interest rates). Therefore, option B is the best choice.