The Non-Income Determinants
of Consumption and Saving
Plus: An Introduction to Investment
and the Interest Rate Relationship
The Non-DI Determinants of
Consumption and Savings
Wealth
Expectations
Taxation
Household
Debt
Wealth
• The value of real assets (houses, land) and
financial assets (cash, stocks, bonds).
• When wealth increases, households increase
spending and reduce savings.
• This is called the wealth effect, and it shifts
the savings schedule down, and consumption
up.
• The opposite occurs when wealth decreases.
Expectations
• About future prices and income.
• Expectations of rising prices in the future will
cause an increase in consumption and
decrease in saving.
• This shifts the consumption schedule upward
and savings downward.
• The opposite occurs when there are
expectations of a recession or lower income.
Taxation
• Taxes are paid at the expense of consumption
and savings.
• If taxes increase, we save and consume less.
• Conversely, tax reductions by the government
encourage us to buy and save more.
• Thinking & Inquiry: Why might the
government be afraid to raise taxes to pay off
the debt during a slow economy?
Household Debt
• Increased borrowing increases current
consumption. This moves the consumption
schedule up.
• Decreased borrowing reduces consumption.
• Thinking & Inquiry: Why at high levels does
increasing levels of debt cause serious
problems for future savings and consumption?
Curve Analysis: “Movement” versus “Shift.”
Making Investment Decisions:
The Main Determinants
Expected
Rate of
Return
•Expressed as
(r)
Interest Rate
on Borrowed
Money
•Expressed as
(i)
Expected Rate of Return
• Businesses only make investments when they
expect them to be profitable.
r = (Expected Revenue - cost of investment) /
cost of investment.
• Firms are risk takers, and returns are not
guaranteed.
The Real Interest Rate and Analysis
• Businesses only invest when the rate of return
is greater than the interest rate (r > i)
• You take out a loan for $1000 to buy a
machine. If the interest rate is 7%, you pay
$70 in interest.
• If the rate of return is 10%, then you generate
$100 extra from the machine.
• Your net profit is $30 ($100-$70)
Test Preparation
• In groups of four, read 191-193.
• Try to explain what you read to each other in
simple and clear language.
• Discuss and complete the following potential
test questions: # 4 and # 6 on pg. 223.