Question

7) We discussed many times, IRs will change given the Liquidity effect, Income effect and Price-level Effect etc…. In your own words describe how IRs will go up due solely to the Income effect (ignore the others).

Answer 1

Assuming the IR represents the Interest Rates

The Income Effect is the change in consumption of goods and services caused by change in purchasing power of the money income with the consumer. Income effect can be direct or indirect.

Income Effect takes place directly when the income of a consumer changes. This has a direct bearing on the consumption of the consumer. So if the income of the consumers increase, the demand of goods will increase. This will result in increase in prices of the goods. In order to stabilise the inflation in the economy, the central banks will increase the interest rates. If on the other hand the income with the consumers decline, they will demand less of the normal goods, which will bring down the prices of the goods. When the general price level in the economy comes down, the central bank will try to induce more liquidity in the market by lowering down the interest rates.

The income effect can be indirect as well. If instead of changes in incomes of the consumer, the purchasing power changes, the consumption pattern of the consumer gets altered. If the general price level of the commodities increase, the purchasing power with the consumers decline, as the consumers will now be able to purchase lesser units of commodities. This happens when the inflation in the economy is high, as a result of which the real income declines. To bring down the inflation level in the economy, the interest rate is increased. On the other hand, when the prices of commodities fall, the demand for money decreases. The real money with the consumer increases. The central Bank decreases the interest rates, to infuse liquidity in the economy, to induce demand and restore prices of goods and generate production and employment in the economy.