The Role of Interest Rates and Inflation in the Consumption Function.

This article discusses the influence of interest rates on consumption during a period of inflation in the United States. Most of the analysis of the effects of interest rate changes on consumption has been concerned with (1) the relative importance of income and substitution effects in determining how households will allocate their resources over time, and (2) the substitution effect at a moment of time determining the demands for durable versus nondurable consumption goods. But two other types of interest rate effects on consumption -- effects that have received little attention in the literature -- may be of some importance and are the subject of this report. The rate of inflation enters the analysis because of the wedge it drives between the nominal and real rates of interest. One of the effects to be considered is a consequence of the fact that the real rate of interest helps determine the services yielded by the stock of consumer durables. Another neglected factor in the study of consumption behavior is the treatment of the gross interest income of households. In calculating real income during an inflationary period, households should take account of the depreciation in the real value of their fixed income assets.