Page 475 - The Principle of Economics

Consumption when Old
Consumption when Old
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
CHAPTER 21
THE THEORY OF CONSUMER CHOICE 485
BC2
BC1
1. A higher interest rate rotates the budget constraint outward . . .
I2
I1
BC2
BC1
1. A higher interest rate rotates the budget constraint outward . . .
I1 I2
Consumption when Young
AN INCREASE IN THE INTEREST RATE.
shifts the budget constraint outward. In panel (a), consumption when young falls, and consumption when old rises. The result is an increase in saving when young. In panel (b), consumption in both periods rises. The result is a decrease in saving when young.
The end result, of course, depends on both the income and substitution effects. If the substitution effect of a higher interest rate is greater than the income effect, Sam saves more. If the income effect is greater than the substitution effect, Sam saves less. Thus, the theory of consumer choice says that an increase in the interest rate could either encourage or discourage saving.
Although this ambiguous result is interesting from the standpoint of economic theory, it is disappointing from the standpoint of economic policy. It turns out that an important issue in tax policy hinges in part on how saving responds to interest rates. Some economists have advocated reducing the taxation of interest and other capital income, arguing that such a policy change would raise the after-tax interest rate that savers can earn and would thereby encourage people to save more. Other economists have argued that because of offsetting income and substitution effects, such a tax change might not increase saving and could even reduce it. Unfortu- nately, research has not led to a consensus about how interest rates affect saving. As a result, there remains disagreement among economists about whether changes in tax policy aimed to encourage saving would, in fact, have the intended effect.
DO THE POOR PREFER TO RECEIVE CASH OR IN-KIND TRANSFERS?
Paul is a pauper. Because of his low income, he has a meager standard of liv- ing. The government wants to help. It can either give Paul $1,000 worth of food
Consumption when Young
Figure 21-16
0
0
2. . . . resulting in lower consumption when young and, thus, higher saving.
In both panels, an increase in the interest rate
2. . . . resulting in higher consumption when young and, thus, lower saving.