2. Expectations: Changes in expected future prices or wealth can affect consumption spending today. 3. Real interest rates: Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Because many household expenditures are not interest sensitive – the light bill, groceries, etc. – the effect of interest rate changes on spending are modest. 4. Household debt: Lower debt levels shift consumption schedule up and saving schedule down. G. Other important considerations: See Figure 8.4. 1. Macroeconomic models focus on real domestic output (real GDP) more than on disposable income. Figure 8.4 reflects this change in the labelling of the horizontal axis. 2. Changes along schedules: Movement from one point to another on a given schedule is called a change in the amount consumed; a shift in the schedule is called a change in consumption schedule, and is caused by non-income determinants of consumption... 3. Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change. 4. Taxation: Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher taxes. 5. Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. H. CONSIDER THIS…The Great Recession and the Paradox of Thrift In response to the Great Recession, households decreased consumption and increased savings. The paradox occurs because an increase in savings during a recession can make the recession worse even though increased savings is better in the long run. At the same time the collective decrease in consumption can actually force households to save less as the reduction in consumption creates an increase in job losses. III. The Interest Rate – Investment Relationship A. Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. 1. The investment decision weighs marginal benefits and marginal costs. 2. The expected rate of return is the marginal benefit and the interest rate – the cost of borrowing funds – represents the marginal cost. B. Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return. The text’s example gives $100 expected profit on a $1000 investment, for a 10% expected
rate of return. Thus, the business would not want to pay more than 10% interest rate on investment. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk. C. The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment. 1. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone.
You've reached the end of your free preview.
Want to read all 24 pages?
- Winter '08
- Inflation, Gdp, gross domestic product, Canada.