Question

Describe how the savings decision can be thought of as a trade-off between current and future consumption. In that context, the price of future consumption is one over one plus the interest rate. Using this logic, explain why savings might rise when the interest rate rises. What is the precautionary model of savings? How might that model predict the opposite effect on savings when interest rates rise.Describe how the savings decision can be thought of as a trade-off between current and future consumption. In that context, the price of future consumption is one over one plus the interest rate. Using this logic, explain why savings might rise when the interest rate rises. What is the precautionary model of savings? How might that model predict the opposite effect on savings when interest rates rise.

Answer 1

Solution

Resources are limited but needs & wants are unlimited.Economics deals with the allocation of these available resources efficiently.

Either money can be used today (or) saved for future use.There should be an incentive for people to save money otherwise they would prefer to consume it now itself.

Price of future consumption is present price * (1+ interest rate)

Here the interest rate is the incentive to save money for the future instead of spending / consuming it now.

So when the interest rates rise,people will save more

Under this model Precautionary savings, people save some part of their money solely for the reason of uncertainity that they are expecting in the future.they believe that in case of uncertainity in the future,they would not be able to earn the same kind of income that they are presently earning,so they want to have some buffer to safeguard their future situation.

When interest rates rise,the people might think that the interest rates will continue in the future.So there is every risk that they might think in the opposite way to the above logic i.e., they save less now thinking that they can instead make it up by start saving after some time when the interest rate offered will become more than that existing now.