Question

"Declining interest rates are good for an economy, since interest sensitive spending will increase.  Furthermore, since a decrease in a government budget deficit (by decreasing government spending and/or raising taxes) increases national savings, and thus, reduces the real interest rate, a deficit-reduction policy will have an expansionary effect in the economy due to the increase in interest sensitive spending."  Is this reasoning correct?  Use theIS-LM framework to explain your answer.

Answer 1

Do Changes in Interest Rates Affect Consumer Spending?

Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence, and the overall health of the economy.

KEY TAKEAWAYS

Central banks adjust target interest rates in a country, raising them to increase the cost of borrowing when the economy is hot, and lowering them to make borrowing cheaper when the economy is sluggish.
When interest rates go up, consumers may be more attracted to saving dollars that can earn higher interest rates rather than spend.
When rates go down, people may no longer wish to save, but instead spend and invest, even taking out loans to consume at low interest rates.

Interest Rate Changes

Central banks adjust interest rates, either up or down,in order to combat inflation or spur economic activity when the economy slows. Interest rates affect the cost of borrowing money over time, and so lower interest rates make borrowing cheaper - allowing people to spend and invest more freely. Increasing rates, on the other hand makes borrowing more costly and can reign in spending in favor of saving.

The ultimate effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in light of the change.

The basis behind interest rate changes as a tool for influencing the economy stems from Keynesian economic theory refers to two competing economic forces that act on consumers, and which can be influenced by interest rate levels: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). These concepts refer to changes in how much disposable income consumers tend to spend or save.

Spend or Save?

An increase in interest rates may lead consumers to increase savings since they can receive higher rates of return. This is outlined in the marginal propensity to save. Suppose you receive a $500 bonus with your paycheck. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the remaining $100, your marginal propensity to save is 0.2 ($100 change in saving divided by $500 change in income).

The current level of rates and expectations regarding future rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5% and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available. If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.

The other side of marginal propensity to save is marginal propensity to consume, which shows how much a change in income affects purchasing levels. If interest rates are low, people may take that $500 bonus and decide its not worth earning next to nothing in the bank. Moreover, they may decide to use that as a downpayment to purchase something worth $1,000, financing the additional $500 with a low-interest rate loan on a credit card, or from a bank.

The government has two levers when setting fiscal policy: it can change the levels of taxation and/or it can change its level of spending.
There are three types of fiscal policy: neutral policy, expansionary policy,and contractionary policy.
In expansionary fiscal policy, the government spends more money than it collects through taxes. This type of policy is used during recessions to build a foundation for strong economic growth and nudge the economy toward full employment.
In contractionary fiscal policy, the government collects more money through taxes than it spends. This policy works best in times of economic booms. It slows the pace of strong economic growth and puts a check on inflation.
Key Terms
fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

There are three main types of fiscal policy:

• Neutral: This type of policy is usually undertaken when an economy is in equilibrium. In this instance, government spending is fully funded by tax revenue, which has a neutral effect on the level of economic activity.
• Expansionary: This type of policy is usually undertaken during recessions to increase the level of economic activity. In this instance, the government spends more money than it collects in taxes.
• Contractionary: This type of policy is undertaken to pay down government debt and to cap inflation. In this case, government spending is lower than tax revenue.