Question

We will assume that consumption depends primarily on disposable income (i.e. C = C(Y −T)). It seems likely that in addition to disposable income, the real interest rate also influences consumption decisions. To show this, we could write the consumption function as C = C(Y −T,r), where consumption is increasing in disposable income but decreasing in the real interest rate. Answer the following questions:

(a) Provide an intuitive explanation for why consumption might decrease as r increases.

(b) Explain how the saving schedule changes when the consumption function is altered in this manner.

(c) Answer part (a) of question 1 using this new consumption function.

Answer 1

Consumption depends on disposable income and the real interest rate as C = C(Y −T,r), where consumption is increasing in disposable income but decreasing in the real interest rate.

(a) Consumption might decrease as real interest rate increases. Consumption expenditure includes the demand for automobile, housing and other large expenditures which are mostly financed through borrowing. As there is an increase in real interest rate, people starft saving more instead of consumption because this borrowing is discourage and consumption is reduced.

(b) The saving schedule will also depend now on the real interest rate. A lower real interest rate will discourage saving because money value of the asset will rise, making the owner of the asset richer. This richness becomes the cause of increased consumption and reduced saving.

(c) It has already been told that the new consumtion function C = C(Y −T,r), depends on the real interest rate. As real interest rate increases, people will save more instead of consumption because this borrowing is discourage and consumption is reduced.