Consider the effect of a fall in the interest rate on consumption. Explain your answer using the substitution effect argument.

Question

Quizplus · Accepted Answer

The Answer is A fall in the interest rate lowers the reward to saving. If the interest rate falls from 10 percent to 5 percent, you earn 5¢ instead of 10¢ per year on every dollar saved. This means that the opportunity cost of spending a dollar today (instead of saving it and consuming it plus the interest income a year from now) has fallen. You will substitute toward current consumption and away from future consumption when the interest rate falls: You consume more today and save less.

Consider the Effect of a Fall in the Interest Rate