Final answer:
When income increases, the interest effect suggests a tendency for interest rates to increase, as both savings and present consumption typically rise. However, the overall impact on interest rates also depends on the interplay of other factors like the substitution effect and market dynamics. The correct option is B.
Step-by-step explanation:
The income effect on interest rates implies that when income increases, the interest rate will likely increase. This is because as income rises, people have a higher preference for future consumption over present consumption—which means they save more. The increased savings mean more funds are available for lending, thus increasing the supply of funds. Consequently, when supply rises, as per financial theory, the interest rate should drop. However, the income effect suggests that with a higher income, both present and future consumption are seen as normal goods, and therefore, individuals may choose to consume more presently as well as save more for future consumption. This dual increase in consumption and savings can put upward pressure on the interest rates as the demand for funds also increases to meet the consumption needs.
Meanwhile, the substitution effect may act in the opposite direction, since an increase in interest rates makes savings more attractive compared to current consumption—hence, potentially increasing savings and reducing the interest rate.