Question

What are the two channels through which an increase in the real interest rate affects consumption decisions? Can we tell which channel has a larger impact in theory? In practice, which channel has a larger impact?  

Answer 1

There are two channels thrrough which increase in real interest impacts consumption decision:

a. Direct Channel- There exists an indirect relationship between rate of interest in the economy and level of consumption decision. As rate of interest increases, consumption expenditure falls and as rate of interest decreases, the level of consumption expenditure increases.

b. Indirect Channel: An increase in the real interest rate increase the level of savings in the economy because savings are positively related to rate of interest. As savngs increases, Consumption = Disposable Income - Savings, will decrease because income if assumed to be fixed. Thus, increase in real interest rate leads to fall in consumption expenditure in the economy.

In practice, indirect channel has a greater impact because real rate of interest directly impacts National Savings which in turn impacts consumption expenditure in the economy.