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In the two-period model with investment, we are confident that an increase in the interest rate will shift consumption downward —even though a higher interest rate increases lifetime wealth— because we are making which of the following assumptions:

Options
A.There is no substitution effect.
B.The substitution effect of a change in the interest rate is always smaller than the income effect.
C.The substitution effect of a change in the interest rate always compensates the income effect.
D.The substitution effect of a change in the interest rate is always larger than the income effect.
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The question is asking us to identify which assumption justifies why an increase in the interest rate leads to lower current consumption, even though lifetime wealth rises with a higher rate. Option 1: 'There is no substitution effect.' This is incorrect because, in an intertemporal choice framework, a change in the interest rate changes the opportunity cost of consuming today vs. to......Login to view full explanation

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