- When an increase in interest rate leads to a decline in savings, it implies that: A. individuals substitute future consumption for present consumption. B. income effect of a higher interest rate is greater than substitution effect. C. savings and interest rate patterns cannot be determined in terms of the income and substitution effect. Correct Answer: B Can anyone explain why is A is wrong
If they substituted future consumption for present consumption, they’d be saving more, not less.
Are you sure? Because if I prefer to consume today (substituted future consumption) and not in the future I’m not saving, I’m consuming instead, so my savings are less.
"When an increase in interest rate leads to a decline in savings"…
The common direction in the economy is on the contrary, right? Interest rate generates an income from savings, or a cost of capital for investments. So, from the consumer perspective, a higher interest rate makes you to save more money (to gain this higher interest income), and when interest rates are too low you look at saving as a foolishness and you prefer to consume more.
But that statement have the opposite direction and it can happens, but when?? When saving more money because interest rates are higher is considered an inferior good, so the income effect is higher than the substitution effect making savings to decline.
What person could behave like this? Maybe a very rich man who prefer to invest or consume when rates rises. I know this is almost no sense, but the questions had that trick hidden.
Remeber we are in the pure context of income and substitution effect only for this analysis, let the other relevant variables constant !
Yes, I’m sure.
If you consume more today (saving less) and less in the future, you’re substituting present consumption for future consumption , not the other way round.
Lol, I think this is a linguistic issue, because I understand it totally the opposite. If I have a rock in point A, and a pencil in point B, and I substitute the rock for the pencil, what object do I have on point A? The pencil, right?
So, if I substitute present consumption for furute consumption, it means I’m replacing present consumption (less consumption and more savings) for future consumption.
It is, indeed, a linguistic issue.
Take my word for it: substituting A for B is intended to mean that you get A, and give up B.
Amazing fact, it is clear now. Thanks!
Happy to oblige.