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:

Question

BlackTom AI · Accepted Answer

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. tomorrow, which induces intertemporal substitution. Ignoring this effect would fail to explain the downward shift in current consumption.
Option 2: 'The substitution effect of a change in the interest rate is always smaller than the income effect.' If the income (wealth) effect dominated, a higher interest rate could raise current consumption for some individuals or at least offset the substitution tendency. The standard result in the two-period model relies on substitution being the stronger force, so this statement contradicts the typical assumption.
Option 3: 'The substitution effect of a change in the interest rate always compensates the income effect.' If the two effects fully offset, there would be no net change in consumption, which contradicts the customary outcome that consumption responds to the rate due to a dominant substitution channel.
Option 4: 'The substitution effect of a change in the interest rate is always larger than the income effect.' This aligns with the intuition behind the statement: a higher interest rate raises the opportunity cost of current consumption, encouraging saving (reducing today’s consumption) even though it increases lifetime wealth; the stronger substitution effect drives the observed downward shift in current consumption.
In sum, the correct assumption is that the substitution effect dominates the income effect, which yields the stated consumption response to a rate rise. The other options fail to capture this dominance or the existence of a substitution mechanism altogether.

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:

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Consider the situation represented in the above figure. Which of the following statements are correct? (Select all that apply)

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