Macroeconomics: Demand, Investment, and Consumption

• The lecture note focuses on demand, investment, and consumption in macroeconomics, specifically in a closed economy.
• It explores the role of real interest rates and income levels (Y) and their impact on the three demand components.

Macro Demand Side (Closed Economy)

• Assumptions about demand-driven production make demand fluctuations important.
• Y = C + I + G represents the components of demand in an economy – Consumption, Investment and Government Spending.

Investments

• An Investment project involves both payments and receipts at different times.
• The nominal interest rate is "the normal" interest rate.
• A discount factor is used to bring all investments to a common value, or present day value, for comparison purposes.
• Discount factor is given by (1/(1+i)) or (1/(1+r)).
• Cash flow can be converted to present value using discounting.

Discount Factor and Present Value

• Comparing project returns with bank placements can be done by ensuring the project yields at least as much as a bank placement, defined as Y = 100 * (1 + r)
• Current day values are obtained by dividing by (1 + r).
• Present values are calculated by Y / (1 + r) = 100.
• This present value calculation determines the internal rate.
• For example, calculating the net present value (NPV) can be given as: NV = - K + (1 / (1 + i))*Y + (1 / (1 + i)^2)*Y = -100 + (1 / 1.05))*60 + (1 / 1.05^2)*60 = -100 + 57.1 + 54.4 = 11.5
• Long-term future revenues are less relevant to present value.

Investment Projects

• NV-1 = 1000
• NV-2 = 500
• NV-3 = 200
• NV-4 = -100
• Only projects with values above 0 will be realized.

Interest Rate for Project Selection

• Lower interest rates promote projects with significant upfront costs but higher revenues later, and vice versa.
• Lower real interest rates promote wind power, railways, oil development, and highways.
• Norway's discount rate (real interest rate) is 4% -- 3% -- 2% depending on project length with a the standard being 4% for up to 40 years.
• It was revised to 4% real interest in 2021 during a low-interest period.
• A real interest rate of 4% now equals a 7% nominal interest rate, considered low for risky projects.
• Projects are evaluated if they are growth stocks versus value stocks.

Climate-Friendly Discounting

• The long-term costs of climate change imply that discounting reduces the value of the distant future.
• Considerations include normal interest rates versus nearly zero to benefit future generations.
• Responses can vary and are often debated.

Real Interest Rate

• Real interest rate is approximately the nominal interest rate minus inflation.
• A discount factor based on the nominal interest rate should be used when starting with a cash flow of nominal costs or revenues.
• a discount factor based on the real interest rate should be used when starting with inflation-Adjusted figures.

Real versus Nominal Interest Rate

• Either real or nominal interest rates affect investment choices and other economic decisions.
• Real interest rates are the standard response.
• Rising interest rates, inflation, and uncertain real interest rates can hinder housing construction.

Lending

• Lending assumes equal interest rates for borrowing and lending.
• Interest rates affect projects regardless of project financing which could be paying interest on borrowed or lost interest.

Investment Function

• I = I (Y, r, z¹) shows that investment depends on income, interest rate and other factors
• I = z¹ + b₁Y − b₂r equation represents these factors.
• Investments depend on how much income is expected and the availability of finances.
• Investments hinge on interest rates, as returns decrease with increased interest expenses.

Interest-Sensitive Investments

• Home building is being cooled by high interest rates where some corporate investments can be less interest-sensitive.
• The use of construction as a "economic regulator" is subject to debate.

Consumption Function

• Consumption depends on income and wealth.
• Current income or lifetime income must be considered.
• Short term income has much impact from an empirical standpoint.
• Credit-constrained households must be taken into account.

Consumption and Interest

• Net borrowers show

  • The substitution effect has a negative effect on consumption, while the income effect has a positive impact

• Net Savers:

  • The substitution effect has a negative effect on consumption, while the income effect has a positive impact

• Assuming interest rate increases have a negative impact on consumption can be demonstrated through microeconomic theory.

Consumption Function - Equation

• C = C(Y − T, r, z^c) is a general form that states consumption (C) is a function of disposable income, the real interest rate (r), and other exogenous factors (z^c representing wealth and other variables).
• Consumption defined in terms of these factors: C = z^c + c1(Y – T) – c2r

Fixed or Floating Rates and Macro Policy

• Floating interest rates are common in Norway, unlike neighboring countries with fixed rates.
• Are interest rate policies more effective in Norway?
• The question is raised whether everyone should have fixed-rate contracts and the consequences of such policies.

Investment Properties

• Even if not a substantial proportion of GDP, investments are of interest since they change a lot during a business cycle.
• Boliginvesteringen er kanskje mer følsomme for norske korte renter enn andre investeringer?
• Boligprisbobler kan utløse finansielle kriser og makroøkonomisk nedgang. Spesielt i Irland og Spania var finanskrisen knyttet til enorme boliginvesteringer.

Government and Taxes

• Taxes and Spendings are policy variables.
• Government spending is relatively stable over macroeconomic cycles.
• Tax revenues depend on private sector income.
• Budget balances tend to be cyclical.