Key Determinants of National Economic Variables

Factors Affecting Consumer Spending

A nation’s consumer spending is affected by:

1. Current Disposable Income: Measured using the Average Propensity to Consume (APC) and Average Propensity to Save (APS).
2. Permanent Income: Based on the life-cycle model, measured using the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS).
3. Wealth: Calculated as assets minus liabilities (e.g., home equity minus mortgage) of a country, representing the sum total of individual residents’ wealth.

Components and Influences on Investment

Investment is composed of:

• Purchase of buildings.
• Equipment (machinery and production tools).
• Additions to stock (or inventory) of inputs and output.

Investment decisions are affected by:

1. Revenues: Firms invest if they are selling what they are already producing.
2. Costs: When production costs rise, investments tend to fall.
3. Expectations: Also known as “market sentiment.” Consumer expectations, which influence firms, are measured through the Consumer Confidence Index.

Supply of Money: Different Measurements

A) M1: Money for Transactions (Most Liquid Money)

M1 includes:

• Metal coins.
• Paper money.
• Checking accounts (or “demand deposits”), meaning money returnable upon demand (historically checks, now often debit cards).

B) M2: Broad Money

M2 includes liquid money plus less liquid assets:

• M1.
• Saving accounts (or Time Deposits*). These are less liquid because withdrawing funds often requires the bank to be given advance notice*. This structure allows clients to receive higher interest rates than standard checking accounts.
• Certificates of Deposit (CDs). Clients can buy CDs from the bank and receive higher interest rates than those offered on standard saving accounts.

Price of Money: Interest Rates

Interest rates depend on:

1. Maturity: The longer the loan term, the higher the interest rate.
2. Risk: The higher the perceived risk, the higher the interest rate, provided collateral exists.
3. Liquidity: The debtor's capability to repay the money at any time. High liquidity decreases interest rates.
4. Administrative Costs: High administrative costs lead to higher interest rates.

Nominal vs. Real Interest Rates

Interest rates are categorized as:

• Nominal: The official stated price on paper.
• Real: The actual return the bank provides, adjusted for inflation.

Real Interest Rate = Nominal Interest Rate – Inflation Rate (i)

Reasons for Demanding Money

People demand money because it serves three primary functions:

1. Medium of Exchange.
2. Store of Value.
3. Unit of Account.

Transaction Demand for Money

This refers to the liquid money people hold, such as cash in their pocket, because they plan to spend it. The amount held depends on the level of income and prevailing interest rates.