dolution

 

1. Since the interest rate is the price of financial capital, a change in the interest rate generates both an income effect and a substitution effect.

 

a. Explain how the substitution effect of an increase in the interest rate influences households’ desired saving.

 

b. Explain how the income effect of an increase in the interest rate influences households’ desired saving. Why does the direction of the income effect depend on whether the household is a net debtor or a net creditor?

 

c. Explain why, for the economy as a whole, the substitution effect is likely to dominate the income effect.

 

d. What is the importance of the result in part (c) for the economy’s supply of financial capital?