Capital Supply

The expressed consumer preferences between consumption today and consumption tomorrow (alternatively, when young and when old) is precisely what defines the supply of financial capital in our stylized market. The important thing to note here is that the difference between the two consumption periods, essentially the gap between what is spend today and what will be spend tomorrow, is equal to the amount that households save today plus any interest rate on that amount.

Therefore, we may ask: "How do interest rate changes affect household saving (and thus the supply of capital) in the market?

1. If the substitution effect of a higher interest rate is greater than the income effect, then households save more.

2. If the income effect of a higher interest rate is greater than the substitution effect, then households save less.

The two possible effects are shown in the diagram above. With a similar thinking that we applied to derive the backward-bending labor supply curve, you may infer that we are going to be faced with a backward-bending savings supply curve.