'Expectations of the future have a significant impact upon consumption and investment decisions made by individuals.' Discuss, in the light of macroeconomic consumption and investment functions.

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Andrew Powell

Part 1: EC1F1B Introductory Economics

Spring Term 2005 Coursework

Question – ‘Expectations of the future have a significant impact upon consumption and investment decisions made by individuals.’ Discuss, in the light of macroeconomic consumption and investment functions.

When individuals consider the most efficient means of distributing disposable income a wide range of factors must be considered. A high priority must be given to considering the likely effect of future occurrences. Indeed many circumstances can force individuals (e.g. a consumer, business manager, entrepreneur etc) to budget a greater amount than normal to consumption expenditure as opposed to investment expenditure or vice versa.

Firstly, we will consider what expectations may result in an individual budgeting a greater amount to consumption whilst allocating a substandard amount to investment. The current income hypothesis states that current income is the main determinant of consumption. Thus, if an individual’s income has or is going to increase, whether it be a permanent or temporary change, then it is common sense to think that he/she will increase the amount consumed and decrease the amount allocated towards saving. Disposable income is a function of consumption plus saving, thus if disposable income increases then the additional income will be distributed in one of these two ways. The marginal propensity to consume (MPC) shows how probable additional income is likely to be spent so if after an increased income the MPC changes from, for example, 0.6 to 0.65 then it means that the marginal propensity to save has decreased from 0.4 to 0.35. Interest rates can also have an impact upon the amount one budgets towards consumption or investment. If the interest rate falls then an individual is less likely to put money into the bank for the sole purpose of earning interest on invested capital. Therefore, if the money is not invested in savings then it may be that the individual chooses to spend instead, although this is not entirely true as there are many other means of using the money to invest; for example, the person could invest in the stock market or use the money to invest in new machinery etc. However, on the whole a lower interest rate encourages consumption as opposed to saving.

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“An investment is defined as any asset into which funds can be placed with the expectation that the invested capital will generate additional positive income; and many investors, will insist that, as a minimum requirement, the investment will preserve its value.”1 

Investment decisions are often made upon expectations of the future. A well-organised, efficient business will not invest in certain factors of production if the likely return is less than the cost of doing so. Hence, if an individual feels that in the near future or over a longer period, returns from investment outweigh the associated benefits of ...

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