Macroeconomics

F I G U R E

3 - 6

Consumption,

C

MPC

1

Consumption

function

Disposable income, Y

ⴚ T

The Consumption

Function

The consump-

tion function relates con-

sumption C to disposable

income Y

− T. The marginal

propensity to consume

MPC is the amount by

which consumption

increases when disposable

income increases by one

dollar.

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and makes the investment. If the interest rate is above 10 percent, the firm forgoes

the investment opportunity and does not build the factory.

The firm makes the same investment decision even if it does not have to bor-

row the $1 million but rather uses its own funds. The firm can always deposit

this money in a bank or a money market fund and earn interest on it. Building

the factory is more profitable than depositing the money if and only if the inter-

est rate is less than the 10 percent return on the factory.

A person wanting to buy a new house faces a similar decision. The higher the

interest rate, the greater the cost of carrying a mortgage. A $100,000 mortgage

costs $8,000 per year if the interest rate is 8 percent and $10,000 per year if the

interest rate is 10 percent. As the interest rate rises, the cost of owning a home

rises, and the demand for new homes falls.

When studying the role of interest rates in the economy, economists 

distinguish between the nominal interest rate and the real interest rate. 

This distinction is relevant when the overall level of prices is changing. The