Explain how a higher rate of return on saving could, at least in theory, lead to lower saving.
Solution
To understand how this could be possible, we must understand the income and substitution effect
of a higher rate of return on saving.
If interest rates rise then the return on savings increase, hence higher savings imply a greater
return. This is known as substitution effect wherein the consumers substitute spending for
savings as return on savings increase. This effect is positive in nature.
There is another effect called income effect which takes place since the individual can now earn
a greater return on her savings. With the increased interest income, the individual can now
reduce her savings on account. In such a scenario where income effect dominates the substitution
effect, higher rate of return on saving could lead to lower saving..
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Explain how a higher rate of return on saving could, at least in the.pdf
1. Explain how a higher rate of return on saving could, at least in theory, lead to lower saving.
Solution
To understand how this could be possible, we must understand the income and substitution effect
of a higher rate of return on saving.
If interest rates rise then the return on savings increase, hence higher savings imply a greater
return. This is known as substitution effect wherein the consumers substitute spending for
savings as return on savings increase. This effect is positive in nature.
There is another effect called income effect which takes place since the individual can now earn
a greater return on her savings. With the increased interest income, the individual can now
reduce her savings on account. In such a scenario where income effect dominates the substitution
effect, higher rate of return on saving could lead to lower saving.
