In Chapter 3, we saw that the return to saving r enters into the decision whether to consume or save. There we alluded to the fact that the effect on saving of a rise in the return to saving depends on the relative strength of the substitution and income effects at work.

The substitution effect results from the fact that, with a higher r, the individual finds that each dollar added to saving brings a higher return in the form of increased future consumption than it did before. If r rises from five percent to six percent, the individual gets $1.06 to apply to next year’s consumption for every dollar saved, rather than $1.05. This operates to increase saving.

The income effect results from the fact that an increase in r makes ...

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