In Irving Fisher's two-period model, the substitution effect of an increase in the interest rate in the first period, for a saver, is the:
A) decrease in the relative price of second-period consumption.
B) additional income earned on first-period saving.
C) decrease in the relative price of first-period consumption.
D) additional income earned on second-period saving.

Question

Quizplus · Accepted Answer

The substitution effect of an increase in the interest rate, for a saver, is the decrease in the relative price of second-period consumption. This is because the higher interest rate makes future consumption cheaper relative to current consumption, encouraging saving.

In Irving Fisher's Two-Period Model, the Substitution Effect of an Increase