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Income Versus Substitution Effects

The document discusses the income effect and substitution effect that occur when interest rates change. The income effect refers to changes in consumption due to changes in income, while the substitution effect refers to changes in consumption due to changes in the relative price of consuming in different periods. When interest rates rise, savers like Carmencita earn more interest income, allowing them to consume more in both periods due to the positive income effect. However, the substitution effect leads Carmencita to consume less in the first period and more in the second period as the present value of future consumption falls relative to current consumption.

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Tanu Nepaul
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25 views1 page

Income Versus Substitution Effects

The document discusses the income effect and substitution effect that occur when interest rates change. The income effect refers to changes in consumption due to changes in income, while the substitution effect refers to changes in consumption due to changes in the relative price of consuming in different periods. When interest rates rise, savers like Carmencita earn more interest income, allowing them to consume more in both periods due to the positive income effect. However, the substitution effect leads Carmencita to consume less in the first period and more in the second period as the present value of future consumption falls relative to current consumption.

Uploaded by

Tanu Nepaul
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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INCOME VERSUS SUBSTITUTION EFFECTS.

We can differentiate two distinct


effects on consumption when interest rates change: the income effect, the change in
consumption due to changes in income, and the substitution effect, the change in
consumption
that occurs from the change in the relative price of consumption in the two
periods. (You may recall a more general discussion of income and substitution effects
from your microeconomics course. For a refresher, refer to the chapter appendix.)
In the scenario shown in Figure 18.5, Carmencita has savings, so she lends money
(probably by depositing the funds in her bank account) from period 1 to period 2. With
a higher rate, Carmencita earns more interest, which gives her more resources with
which to consume. Thus, she can spend more in both periods. For savers, the income
effect increases consumption in both periods when interest rates rise.
With a higher interest rate, the present discounted value of consumption in the second
period falls, so consumption in the second period becomes cheaper relative to consumption
in the first period. As a result, Carmencita will choose to substitute away
from and reduce first-period consumption to consume more in the second period. The
substitution effect from higher interest rates leads to less consumption in
period 1, but more consumption in period 2.
We can also think of the substitution effect in terms of saving. When interest rates
rise, the return to saving is higher and so a consumer will save more in the first period
by reducing consumption, enabling her to spend more in the second period (consumption
rises).

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