Compare the determinants of consumption with investment. Most economists regard investment as being less stable than consumption. Looking at the determinants of each factor, support this contention.

Question

What will be an ideal response?

Answer 1

The non income determinants of the consumption schedule are consumer wealth, expectations, real interest rates, household borrowing, and taxation. The determinants of investment are price of investment goods and their maintenance and operating costs, business taxes, technological change, stock of capital goods on hand, and expectations. Comparing the two lists there are some similarities. For example, both include expectations, related price levels, and relevant taxes. However, the technological change and the stock of capital goods on hand have no analogy in the consumption determinants.
These latter two determinants of investment support the contention of economists that the investment schedule is more unstable than the consumption schedule. Technological change is difficult to predict and certainly its impact would vary depending on the extent of the change. The stock of capital goods on hand is a result of previous investment and because of the nature of most capital goods, they can be made to last for a long period of time. Once new capital spending occurs, it is “lumpy” in the sense that it will not be repeated gradually, but only again when the particular capital good wears out or becomes obsolete. Only the durable goods component of consumption is similar, but most of consumer spending is of the more immediate type such as nondurable goods and services which are primarily related to income and would not vary greatly from period to period for most consumers.
The basic determinant of consumption is the level of income, but non income factors include wealth, expectations, real interest rates, household borrowing, and taxation. Aside from a drastic change in government tax or transfer policies, the consumption schedule is quite stable. That is, changes in disposable income are accompanied by predictable changes in consumption spending. Furthermore the other factors are quite diverse and tend to be self-canceling across the population.
The two basic factors determining the level of investment spending are the expected rate of return and the real interest rate. Since the former is based on expectations and the latter based to a large extent on monetary policy, there is potential for wide variation. Add to this the fact that investment goods are usually quite durable, and new investment can be postponed depending on expectations, or once it is made there will be a period of time before the new capital goods will need to be replaced. Also the fact that innovations occur irregularly leads to the inability to plan for gradual investment in innovative technology. Finally, actual current profits are often not as expected, so businesses can be expected to shift their investment plans from year to year.