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
The Investment Demand Curve
16%
14%
12%
10%
8%
6%
4%
2%
0%
$ 0
5
10
15
20
25
30
35
40
16
Expected Rate of Returm
Cumulative
Amount of
Investment
Having This
Rate of
Expected
Return or Higher
Rate of
(i)
Return (r)
14
12
10
8
6
4
ID
2
0
5
10
15
20
25
30
35
Investment (billions of dollars)
40
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