Explain, using the substitution and income effect, the effect of an increase of the capital market's...
Explain, using the substitution and income effect, the effect of an increase of the capital market's interest rate. (tip: assume 2 type of agents: net borrowers and net lenders).
a. According to the substitution effect, what happens with each type of agents savings?
b. According to the income effect, what happens with each type of agents savings?
c. What is the global (aggregate) result in terms of savings?
Homework Answers
a) According to substitution effect, net borrowers take less amount of loans and net lenders savings increases.As because of substitution and income effect, the effect of an increase of the capital market's interest rate will be observed and as a result, due to substitution effect, lenders will lend more in order to get higher interest rates on their investment from the investment in substitutes, on the other hand, net borrowers will decrease as they will not be able to repay the loanable amount at that high interest rate.
b) According to income effect, net borrowers take more amount of loans and net lenders savings or investment increases. As because of substitution and income effect, the effect of an increase of the capital market's interest rate will be observed and as a result, due to income effect the purchasing power will rise and hence, lenders will lend more and borrowers will take more loans as they have enough money in hand to repay.
c) Global savings glut is the global aggregate result in terms of savings. It means that a situation when desired savings is greater than the desired investment. It can be explained along the lines of real long-term interest rates and their associated capitalization rates.
note:
Two concepts:
- Substitution effect: It refers to the substitution of one commodity for the other when it relatively becomes cheaper.
- Income effect: It refers to the change in quantity demanded when real income of the buyer changes owing to change in price of the commodity.
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