Question

What is the likely chain of events if asset prices rise?

a. People feel wealthier, so their spending falls and their saving rises, causing interest rates to fall.
b. People feel wealthier, so their spending rises and their saving falls, causing interest rates to rise.
c. People feel poorer, so their spending falls and their saving rises, causing interest rates to fall.
d. People feel wealthier, so their spending rises and their saving rises, causing interest rates to fall.

Answer 1

b) People feel wealthier, so their spending rises and their saving falls, causing interest rates to rise.

Step-by-step explanation:

If assets price rises, for example, the price of stocks in the market, people will feel wealthier because they now have more disposable income. As consumption is a function of disposable income, as stated by the consumption formula:

C = a + MPC*Yd

Where

C = consumption

a = autonomous consumption (consumption that does not depend on disposable income)

MPC = marginal propensity to consume

Yd = disposable income

if disposable income is higher, then consumption will be higher.

People save whatever money is left after consumption. If people consume more, then, their savings will fall.

Less savings means that the supply of loanable funds will fall, causing a rise in the interest rates.