Question

In the neoclassical consumption model with log utility functions for current and future consumption, an increase in the interest rate will increase the growth rate of consumption. true or false and why

Answer 1

A ) False

consumption won't grow as a result of rise in interest rate. . Total wealth depends on Interest rate because it includes the present discounted value of labour . Higher interest rate will reduce theis present value in general and it will therefore reduce consumption in the case of log utility. This force is called wealth effect of a higher interest rate because it works through the total wealth term.

Note :changes in interest rates often involves substitution effect and income effect. In the case of log utility these effects offset each other . Substitution effect of a higher interest rate is that current consumption is more expensive ( because savings will lead to even more consumption in the future). So the consumers will tend to reduce consumption today. The income effect says that - the consumers are now richer- because current saving leads to more income in future -which makes them wants to consume more today. In general,higher interest rates can either rise or lower current consumption because these effects work in opposite directions.