 Factors affecting consumption and saving, real interest rate, substitution and income effects. Dear students, in the last modules we discussed how current income, future income, or change in wealth will affect the decision of consumption and saving. Today we will discuss how the change in interest rate will affect consumption and saving. Interest rate is actually the price of current consumption in terms of future consumption. This means that in terms of future consumption, we spend 1 plus R times rupees. If we are spending 100 rupees today, then tomorrow we will not be able to spend 110 rupees. If the interest rate increases, then the price of current consumption will be 120 rupees. In this way, interest rate determines the price of current consumption in terms of future consumption. So, if there is an increase in the interest rate, how this will affect your current consumption and saving? We will study this in two ways. It will affect income effect and substitution effect. We have already discussed that these two effects will move in the opposite direction. What is substitution effect? Actually, when the interest rate increases, then your saving will positively affect. Why will it positively affect? Because the reward of saving has increased. Today we are saving 100 rupees. In the future, you will get more money than before. So, the reward of saving has increased. So, individuals will save more. We can also see that individuals will substitute their current consumption in terms of future consumption. Because future consumption is now relatively less expensive. Current consumption is expensive because R is the price of current consumption. By increasing R, current consumption becomes expensive. And whatever becomes expensive, individuals use it first. So, current consumption will decrease and this means that its current saving will increase. So, what will happen in the result of substitution effect? By increasing the interest rate, your saving will increase. The second effect is the income effect. When the interest rate increases, then the consumer will feel richer or poorer than before. What will this depend on? It will depend on the fact that if an individual is a net saver, then he will feel richer than before. Because now the reward of saving has increased. And if he is a net borrower, he has taken a curse. So, because of increasing the interest rate, he will feel poorer if he has to pay more than before. So, if he is a net saver, what will happen in this situation? The income effect will be negative on the saving. How will it be negative? By increasing the interest rate, he will feel richer than before. Whenever he feels better, he will increase the current consumption. Increasing the current consumption means that the current saving will decrease. So, by increasing the interest rate, the current saving will decrease due to the income effect. If you recall, what happens because of the substitution effect? By increasing the interest rate, the current saving increases and the income effect decreases. So, in this context, I told you that you will move in the opposite direction of each other. And if he is a net borrower, then what will happen? The interest rate has increased due to the net borrower. Before that, you have to pay more than before. He is feeling poorer. He will have to save more. He will reduce the current consumption and increase the saving. So, if you link this with the substitution effect, the net saver or the net borrower increases due to the increase of the interest rate. But here, because of the income effect, the savings are increasing due to the borrower. So, these two are moving in one direction and the income effect is moving in the same direction, while the saver or the net borrower will move in the opposite direction. So, what will happen with the net effect? Obviously, in the saver, the theory does not tell us what will be the net effect. The net effect will depend on which of the two is stronger. If the substitution effect is stronger, then your saving will increase and if the income effect is stronger, then your saving will decrease. But in the case of the borrower, the theory is clear that the savings are increasing due to the substitution effect and the savings are increasing due to the income effect. So, the net effect will increase in the saving due to the borrower. The income and substitution effect will be clear in the same direction and the net saving in the same direction will be ambiguous in the same direction. What will happen to the national saving? In the national saving, both the borrower and the saver will also be added. So, the theory cannot tell us what will be the overall effect. To see this, we will have to go to the empirics. We will have to see empirically what data shows. So, unfortunately, data does not give us a clear picture. It gives us mixed results. But normally, when the interest rate increases, then the aggregate savings will increase but there will be no strong effect. It will slightly increase. Thank you very much.