How does an increase in the interest rate affect households’ desire to
save? The interest rate is the “price” of financial capital. Like any price,
the interest rate represents an opportunity cost—it is the opportunity cost
of spending now rather than in the future. For example, suppose the
interest rate is 5 percent per year. Your decision to spend $100 now
“costs” you $105 in forgone spending one year from now. An increase in
the interest rate increases the “price”—or opportunity cost—of current
spending. Households respond to an increase in the interest rate by
substituting away from (relatively expensive) current spending and
toward (relatively inexpensive) future spending.
An increase in the interest rate causes households to reduce their spending and increase their
saving, thus increasing the quantity of financial capital supplied.3 This is the substitution effect of an increase in the interest rate and it works in the same direction
for all individuals. There is also an income effect, which operates in one direction for households
with negative net assets (debtors) and in the opposite direction for households with positive net
assets (creditors). Economists usually assume that, when summed across all households in the
economy, some of which are debtors and others creditors, the overall effect of a change in the
interest rate is dominated by the substitution effect.
3