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= ( )/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 Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (i) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ Expected Rate of Returm 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