Assume that Krystal has positive wealth. As the interest rate increased, Krystal increased her current consumption. For Krystal
A) the substitution effect of an interest rate increase outweighs the income effect.
B) the income effect of an interest rate increase outweighs the substitution effect.
C) the substitution effect of an interest rate increase must be zero.
D) the income effect of an interest rate increase must equal the substitution effect.

Question

Quizplus · Accepted Answer

According to the income effect, an increase in interest rates leads to an increase in income from savings, which leads to an increase in consumption. The substitution effect suggests that an increase in interest rates leads to an increase in savings, which then leads to a decrease in consumption. Since Krystal increased her current consumption as the interest rate increased, it suggests that the income effect outweighed the substitution effect.

Assume That Krystal Has Positive Wealth