Question

In the two-period model, if the consumer is initially a saver, the interest rate increases and first-period consumption decreases, then we can conclude that the income effect:___________

a) was less than the substitution effect.
b) and the substitution both increased consumption.
c) was greater than the substitution effect.
d) exactly offset the substitution effect.

Answer 1

A) was less than the substitution effect.

Step-by-step explanation:

The income effect refers to the change that prices changes cause to real income, when prices decrease, households are able to purchase more goods with the same amount of income. The substitution effect refers to how consumers' habits are affected by changes in the price of closely related goods or services.

In this case, the change in interests rates makes consumption more expensive, therefore, households will substitute consumption for saving (money not spent is saved).

Answer 2

c) was greater than the substitution effect.

Step-by-step explanation:

The income was made through reduction in consumption. Due to higher interest rate made, the income made surpassed the substitution effect