Question

Why does an increase in the interest rate generate a substitution effect? Why does it produce an income effect? Does the substitution effect depend on whether one is a saver or a borrower? What about the income effect?

Answer 1

Increase in interest rate can generate both subsititution and income effects.

An increase in interest rates makes consumption expensive in the current period. This leads to people trying to reduce their consumption by substituting with less expensive goods and services. This is the substitution effect which is caused by the increase in interest rate.

However, with the increase in interest rate, the interest income of consumers also increases since they now receive a higher interest on their savings. This increase in income could lead to consumers demanding more consumption of normal goods. This is the income effect which can be attributed to the increase in interest rate.

Yes, the substitution and income effects can depend on whether one is a saver or borrower. If the person is a net saver, his income would increase as his savings would now generate higher interest income due to the increased interest rates. This would lead to an increase in consumption by the person due to income effect.  However, if the person is a net borrower, consumption in the current period will become more expensive due to the increased interest rate. Therefore, the person is most likely to substitute his current consumption with cheaper alternatives. This is the subsittution effect caused by increase in interest rate.