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'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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Introduction

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. ...read more.

Middle

Most individuals will have a choice of a range of investment decisions and they need to have a basis for comparing them to evaluate which is the best. A part of this evaluation has to be based on a financial assessment of the projects ('qualitative factors') and partly also on non-financial factors ('qualitative decisions'). Once again, in the financial sense, an investment must be profitable and more worthwhile than if the money was used for consumption and, furthermore, it should earn an expected rate of return that is well above the safe interest rate to allow for risk. As regards to expectations of interest rates, if it looks likely that in the near future the rate will experience a sufficient decline then it could tempt the individual to allocate a greater amount towards investment as opposed to consumption. For example, the individual will be able to borrow a set amount and the value which is required to be paid back will be less if the interest rate is low than if it is high, thus making an investment more cost effective. The life cycle hypothesis gives a greater understanding of the impact expectations of the future can have upon consumption and investment decisions made by individuals. ...read more.

Conclusion

"Firms base investment decisions on value of outstanding stock relative to replacement cost of capital. Market value of current capital depends upon the value of firms shares, which in turn depends upon expectation of future profits from this capital"3 This model, therefore, is only of great use to a company with a stock listing. It shows that a company should increase investment if the stock market values it at more than the cost to replace all its capital and that it should continue to do so until an equilibrium is met, whereby the stock market valuation equals the cost of replacement capital. The argument put forward seems to agree with the viewpoint that expectations of the future can have a major impact upon consumption an investment decisions made by individuals. Indeed, many macroeconomic functions support the idea. Evidence suggests that if one has or expects an increase in real income then consumption will be increased, whilst the marginal propensity to save decreases. Maybe the opposite will occur if individuals expect real income to decrease in the near future. Interest rates and its expectations can be of importance to the decision an individual makes regarding consumption or investment. Furthermore, the individual's level of wealth can have a bearing; if one has a high level of wealth then a greater percentage may be used for consumption purposes. ...read more.

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