Chapter 8

Presentation 2

Determinants of Consumption and Saving

• ***The amount of DI is the basic determinant of consumption and saving

• There are also Non-income Determinants:

• 1. Wealth

• 2. Expectations

• 3. Real Interest Rates

• 4. Household Debt

1. Wealth

• Includes both real assets (houses, land) and financial assets (cash, savings accounts, stocks, bonds)

Wealth Effect- When existing wealth increases, people will consume more and save less. When wealth decreases, people will save more

2. Expectations

• If people expect prices to go up in the future, they may consume more now

• If a recession is predicted, people will likely save more now

3. Real Interest Rate

• Adjusted for inflation

• =nominal interest rate – the expected rate of inflation

• When interest rates fall, household tend to borrow more, consume more and save less

• Saving is less because of reduced interest payments

4. Household Debt

• If households borrow more (take on debt) they are able to consume more

Expected Rate of Return

• ***Not a guarantee, rather a prediction***

• r= profit/cost of the investment

• Ex- a machine will cost a company $1000. The net expected revenue (after taxes, labor, utilities) gained from the machine is $1100.

• r= (1100-1000)/1000

• = 10%

Real Interest Rates and Investment

• Companies should invest in project up until the point where r = i

• As long as the expected rate of return (r) exceeds the interest rate, the project can be expected to be profitable

Interest Rate and Investment

ExpectedRate of

Return (r)

CumulativeAmount ofInvestmentHaving This

Rate ofReturn or Higher

(i)

16%14%12%10%

8%6%4%2%0%

$ 05

10152025303540

Exp

ecte

d R

ate

of

Ret

urm

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40

Investment (billions of dollars)

The Investment Demand Curve

ID

Shifts of the Investment Demand Curve

• 1. Operating Costs

• 2. Business Taxes

• 3. Technological Changes

• 4. Stock of Capital Goods- extra capital will lead to less need for investment

• 5. Expectations