Expected income and sales influence spending decisions.
Consumption depends on disposable income, wealth, confidence, borrowing conditions and expectations about future income or prices. Investment depends on expected future sales and profitability, financing costs, business confidence, available capacity and technology. A lower interest rate can support borrowing and reduce the return to postponing some purchases, but weak expected sales can still discourage investment. State what changes, which expenditure component is affected and why. A change in the general price level causes movement along AD under the model; a change in these other determinants can shift AD.
- Consumption
- Disposable income is income available after subtracting direct taxes and adding government transfers. More of it can support consumption. Wealth, job confidence and access to borrowing also affect household choices.
- Investment
- The interest rate is a borrowing cost, as well as a return to saving. Firms compare financing costs with expected sales and returns when deciding whether to buy more productive equipment.
- Conflicting influences
- Cheaper borrowing can encourage investment, while weak sales expectations and unused machines reduce the need for it. Their combined effect is not certain from the interest rate alone.
Apply the idea
Confidence mechanism
Greater job security can reduce the money households set aside for emergencies and encourage consumption at a given income and price level. That response depends on their circumstances; confidence does not guarantee everyone spends more.
Capital timing
Buying domestically produced equipment or installation services adds to AD now; imported production is offset through M. Once installed and effectively used, the equipment may let firms supply more at a given price level, shifting AS down/right. Spending comes before that possible supply benefit.
Worked example: Cheaper loans but fewer expected orders
Interest rates fall, but a manufacturer expects fewer orders next year and already has unused machines. At the same time, households become more optimistic about job security. Hold other demand determinants constant.
- Lower borrowing costs make some investment projects more attractive, other things equal.
- However, weaker expected sales and existing spare capacity reduce the need for new machines. The net investment response is not certain from the interest-rate change alone.
- Improved household confidence can raise current consumption at each general price level, supporting a rightward AD shift.
- Assess the combined size of the C and I changes before concluding how much total AD changes.
Watch out for this
Lower interest rates guarantee that all firms invest more.
Expected demand, profitability, capacity and access to finance also matter; effects can offset one another.
Check your understanding
Which most directly supports higher planned investment, other things equal?
- Stronger expected sales with existing capacity nearly fully used.
- A purchase of existing shares alone.
- A belief that every machine purchase is household consumption.