14.

3 Households’ target wealth (Part II)

 Context of Unit 14 Part II

• In Part I we have seen that consumption (C) and investment spending

(I) are two components of the aggregate demand model.

• In 14.3 and 14.4 we take an even closer look at these components

and which factors influence them

2
 Outcomes for Part II of Unit 14
• Explain how changes in household target wealth affects
autonomous consumption expenditure.
• Explain the factors which led to the Great Depression.
• Understand the factors that influence investment
expenditure.
• Differentiate between shifts of and movements along the
aggregate investment function.

3
 14.3 Households’ target wealth

We have seen how a change in investment shifts the

aggregate demand curve. Let us now look at how
changes in autonomous consumption (precautionary
saving) also shift the aggregate demand curve.

4
 Households’ savings rate in South Africa in 2023
“Household Saving Rate in South Africa decreased to -0.20 percent in the first quarter of 2023 from 0 percent in the fourth quarter of
2022” (tradingeconomics, 2023).

Source: https://tradingeconomics.com/south-africa/personal-savings
5
 14.3 Households’ target wealth
• Households have a wealth which they aim to preserve. This wealth is
called target wealth.
• Changes in household wealth stocks: Households will change their
savings patterns to restore household wealth if the value of its assets
(such as a house) decreases relative to its target wealth.
• Precautionary savings, is the increase in savings as a result of a
decrease in the value of a household’s assets.
• Precautionary saving behaviour by households is modelled as a fall in
autonomous consumption
• Remember pathway: Fall in investment, fall in output, fall in
employment, fall in income, fall in consumption expenditure and
wealth, increase in saving
6
 Household wealth
Figure 14.7 household wealth: Key concepts

Broad wealth = broad assets – debt

 Household wealth impacts autonomous consumption expenditure
Figure 14.8 The Great Depression: Households cut consumption to restore their target broad wealth

A fall in expected earnings

will lead to cut in
consumption expenditure
(precautionary savings) to
restore wealth to the level of
target wealth.
 The Great Depression
Point A: goods market equilibrium (1929) Figure 14.6 Aggregate demand in the Great Depression

Point B: fall in investment = downward shift of

AD
Point C: fall in autonomous consumption
expenditure = further downward shift of AD
• uncertainty due to stock market crash,
pessimism, banking crisis and collapse of
credit

• Households who retained their jobs also

cut back on spending
 The Great Depression
• Two ways which consumption expenditure fell during Great Depression:

1. Credit constraints in the multiplier process (point A to B).

2. Changes in wealth relative to target wealth (point B to C).

• Multiplier process: The fall in AD because of a fall in investment, led to a reduction in output,
employment etc.
• Target wealth process: Housing prices fell which led to the wealth of households falling and
precautionary saving increasing which meant a fall in autonomous consumption expenditure
• Great Depression: Happened because of multiplier effect AND target wealth process. Without the
reduction in household consumption, there would have only been a recession.

10
 Household wealth
How did target wealth impact consumption expenditure in Great Depression?

• If target wealth is above expected wealth: Decrease in consumption

expenditure and increase in savings.
• If target wealth is below expected wealth: Increase in consumption
expenditure and decrease in savings.
• The onset of the economic downturn led to job losses which led to pessimism
and a downward revision of expected income.
• Housing prices also decreased which led to a large gap between target wealth
and expected wealth

• Financial accelerator: Low housing prices meant that households and firms
cannot borrow as much as before because their collateral is worth less. This
means that they are credit constrained and leads to decreased consumption.11
 Household wealth and credit constraints
Household wealth and credit constraints:

• For those who are not credit-constrained: If the value of your house
increases, this improves your net worth and raises your wealth
relative to target. We would predict that this would reduce your
precautionary savings, increasing consumption.

• For those who are credit-constrained: A rise in the price of your

house can lead you to increase your consumption expenditure
because the higher collateral enables you to borrow more.
 Exercise
Question 1
Why is precautionary saving seen as a decrease in autonomous
consumption expenditure?

Question 2
What role did house prices play in the Great Depression?

Question 3
Explain the role of expectations about future earnings in household
consumption expenditure patterns.
13
14.4 Investment
 14.4 Investment
Firms’ decision about what to do with its profits depends on
• Owner’s discount rate (ρ)
• Interest rate on assets (r)
• Net profit rate on investment (Π)

1. Consume the extra income (dividends) if ρ > r ≥ Π

2. Save the extra income/repay debts if r > ρ ≥ Π
3. Invest (at home or abroad) if Π > ρ ≥ r

A lower interest rate makes investment more likely.

Supply side factors vs demand side factors
• Supply-side factors are those factors which affect or
influence (or are concerned with) the supply of goods and
services (e.g. a business tax cut, an expected decrease in
profits for the firm).

• Demand-side factors are those factors which affect or

influence (or are concerned with) the demand of goods and
services.
 Investment: supply side effects
• Higher expected rate of profit increases investment, holding
r constant.

• Improvement in business environment (reduced risk) also

increases investment.
 Investment Figure 14.9: The effect of interest rates on investment

• A lower interest rate makes

investment more likely.

20
 Investment: supply side effects
Figure 14.10a: The effect of profit expectations on investment
Higher expected rate of profit
increases investment, holding r
constant.

Improvement in business
environment (such as fall in the
risk of expropriation by the
government) also increases
investment.

21
 Investment: demand side factors

A change in the interest Figure 14.10b: The effect of a permanent change in demand
on investment
rate is a demand-side
factor.

(Note that monetary policy

can influence r)

22
 Aggregate investment function
Figure 14.10c Aggregate investment function: Effects of
the interest rate

Aggregate investment function

= An equation that shows how
investment spending in the
economy as a whole depends
on other variables (interest rate
and profit expectations).

• In practice, investment is not very sensitive to interest rate.

• C to E investment increases when the interest rate falls. 23
 Aggregate investment function

Aggregate investment function

= An equation that shows how
investment spending in the
economy depends on other
variables (interest rate and profit
expectations).

In practice, investment is not very sensitive to interest rate. Instead,

the shift factors are much more important.
 Aggregate investment function

Aggregate investment function =

The shift factors are the other
determinants of investment:
Expectations, the level of
economic activity, the stock of
capital, the capacity utilization
rate, the cost of capital goods,
other factor costs, technological
change, and public policy.
What shifts the investment function?

Supply-side factors Demand-side factors

• Fall in expected • Permanent increase

input prices in demand puts
• Improvement in pressure on existing
the security of capacity and raises
property rights the desired size of
• Net profit investment projects
expectations
 Additional exercise
• CORE question 14.5
 Question 14.5

Which of the following statements is correct?

A. Ceteris paribus, an increase in the interest rate would lead to a fall in

investment due to an inward shift of the investment line.
B. A rise in corporate tax would shift the investment line outwards.
C. A forecast of a permanent demand increase shifts the investment
line outwards.
D. A steeper line indicates the higher sensitivity of the level of
aggregate investment to changes in interest rate.
 Summary
• A shock to investment shifts the aggregate demand curve, and is transmitted
through the economy as households adjust their spending in response to
changes in income.
• When something happens to affect the stock of the household’s wealth relative
to their target level, it reacts by either increasing or decreasing its savings to
restore wealth back to its target level.
• The Great Depression occurred due to the multiplier effect and the target wealth
process.
• A firm’s decision about what to do with its profits depends on the owner’s
discount rate (ρ), interest rate on assets (r), net profit rate on investment (Π).
• Empirical evidence suggests that business spending on machinery and
equipment is not very sensitive to the interest rate.