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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.