The Ambiguous Effect of an Increase in Expected Real Interest Rate on Desired Saving

How do income effect and substitution effect impact desired saving in response to an increase in expected real interest rate?

Why is the effect on desired saving of an increase in the expected real interest rate potentially ambiguous?

The effect on desired saving of an increase in the expected real interest rate is potentially ambiguous due to the income effect and the substitution effect.

The income effect and substitution effect play crucial roles in determining the impact of changes in expected real interest rates on desired saving. The income effect refers to the change in savings caused by a change in income level, while the substitution effect relates to the change in savings caused by a change in the relative price of consumption today versus consumption in the future.

When the expected real interest rate increases, it affects the return on savings. The income effect may lead individuals to save more to take advantage of the higher interest rate, while the substitution effect may make saving more attractive compared to immediate consumption.

Therefore, the conflicting influences of the income effect and the substitution effect result in an ambiguous effect on desired saving in response to an increase in the expected real interest rate. The final impact will depend on the relative strength of these two effects.

In conclusion, an increase in the expected real interest rate can lead to uncertainty in the desired saving as individuals may respond differently based on the income effect and the substitution effect. It is essential to consider both effects to understand the overall impact on saving behavior.