George is saving money from his summer job to pay for his college textbooks in the fall. He expects to need $?

Question

George is saving money from his summer job to pay for his college textbooks in the fall. He expects to need $500, and he is currently earning 1% a month interest on his money. His parents are so impressed that George is working and saving money that they agree to pay him an additional 25% interest per month on the money he saves.

George is now earning a higher rate of return on his saving. Which of the following statements is true?

I. The income effect of the higher return on saving causes George to save LESS money.

II. The substitution effect of the higher return on saving causes George to save MORE money.

III. The income effect of the higher return on saving causes George to save MORE money.

IV. The substitution effect of the higher return on saving causes George to save LESS money.

A. I and II

B. III and IV

Answer 1

This question is tricky: If George would be buying McDonald's hamburgers, the income effect causes him to buy MORE burgers, while the substitution effect causes him to buy LESS (because he buys more expensive, higher-quality burgers instead as his income increases).

But this question is about saving to reach a goal of $500. The higher interest rate makes George wealthier. Since George's parents pay him an additional 25%, he has to save LESS to reach his goal of $500. Hence, "[t]he income effect of the higher return on saving causes George to save LESS money". But George may also want to save money for something else, a laptop for example. The higher interest rate therefore induces him to save MORE money (because he now saves for a laptop, which he could have not afforded prior to the higher interest rate).

So, answer A is correct.