Assume that the substitution effect is large relative to the income effect. If a tax reform is designed to increase saving, what does it do to the interest rate and spending on capital goods?
A) It increases the interest rate and decreases spending on capital goods.
B) It increases the interest rate and increases spending on capital goods.
C) It decreases the interest rate and increases spending on capital goods.
D) It decreases the interest rate and decreases spending on capital goods.

Question

Quizplus · Accepted Answer

If the substitution effect is large, a tax reform that encourages saving will likely lead to a decrease in the interest rate as more funds become available for lending. This lower interest rate makes borrowing cheaper, encouraging increased spending on capital goods.

Assume That the Substitution Effect Is Large Relative to the Income