Working Paper No. 243
By Roy Cromb and Emilio Fernandez-Corugedo
This paper examines the sensitivity of the level of consumption to interest rates in a standard partial equilibrium theoretical framework with no uncertainty. Using a multi-period framework, the consumption function is derived and interest rate effects are decomposed into substitution, income and wealth effects. Drawing on parallels with the finance literature, the paper illustrates two key implications of the theory that are not typically emphasised in the economics literature. First, it shows that wealth effects mean that consumption is much more likely to be negatively related to interest rates than the simple two-period textbook model might suggest. Second, it demonstrates that long-term interest rates are more important than short-term rates – the sensitivity of consumption to interest rate changes depends crucially on how long these are expected to persist. Numerical calibrations provide an indication of the sensitivity of the results to key parameters.