Question

2. Graphically illustrate and explain how an increase in the interest rate would affect consumer spending.

Answer 1

Changes in interest rates affect the 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 confidenceand the overall health of the economy.
• It's possible for interest rate changes, either up or down, to have the effect of increasing consumer spending or decreasing spending and increasing saving. The ultimate determinant of the overall 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.
• Keynesian economic theory refers to two conflicting economic forces that can be influenced by interest rate changes: the marginal propensity to consume (MPC)and the marginal propensity to save (MPS).These concepts basically refer to changes in how much disposable income consumers tend to spend or save.

An increase in interest rates may lead consumers to increase savings, since they can receive higher rates of return. An decrease in interest rates is often accompanied by a corresponding increase in inflation, so consumers may be influenced to spend less if they believe the purchasing power of their dollars will be eroded by inflation.

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 overall health of the economy impacts consumer reaction to interest rate changes. Even with rates at attractively low levels, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also affect how much consumers are willing to extend themselves in spending and in financing obligations

• Consumer function states that consumer spending depends on the income of the consumer. The income is further divided into investment and saving. According to Keynes, aggregate consumption is a function of current disposable income. The psychological law of consumption given by Keynes states that the rate of increase in income is greater than the rate of increase in consumption.
• One of the factors which affect the consumer's spending is the expectation of the consumer. When the consumer's expectations increase, consumer spending will decrease. This is so as the consumers are rational and they demand more when the prices are less as per the law of demand other things remaining constant.
• Interest rate is the function of savings. When interest rate is higher then the people are attracted towards saving as they would gain more but if the interest rate is low then the consumers will prefer to invest rather than save as they will not gain enough interest out of it. This will result in changes in consumers spending. When the interest rate is high, consumers save and thus less consumer expenditure. On the other hand, when the interest rate is low, people do not save and therefore consumer spending will increase.
• There is a direct relationship between income and consumers expenditure. As the income of the consumers increases the demand for the goods increases and thus there is an increase in the consumer's expenditure or spending as per the law of psychological law of consumption stated above. Therefore an increase in consumer income will increase the consumer's spending. This can be shown from the diagram below: