Why do auto manufacturers offer low interest rates on some new vehicles, and does monetary policy, consumer sentiment and changes in nominal interest rates effect the consumers decision?

Douglas A. Brewer, Economics undergraduate student, The University of Akron, October 27, 2004----Module 4

Currently in the automotive industry there are several incentive programs which include but are not limited to special interest rates for certain vehicles. I would like to focus on the Toyota Camry, which generally qualifies for such programs. These plans help consumers maximize their utility, whereas consumer equilibrium might not be achieved without this assistance. I also want to show that the monetary policy of the Federal Reserve has a significant impact on consumer expenditures for durable goods like the Camry. On a final note, the exploration of consumer sentiment and changes in nominal interest rates can help explain consumer behavior.

The sale of a new vehicle generally requires a finance plan of some sort in order for a

transaction to be completed. Currently, many of the major automobile manufacturers offer incentive programs to assist in the sale of their vehicles. The Toyota Camry, for example, currently has in interest rate program for Tier 1 and 2 buyers consisting of interest rates at 0 percent for 36 months, 1.9 percent for 48 months or 1.9 percent for 60 months. “Economists also assume that the consumer is rational…in the sense that he or she tries to get on the highest possible indifference curve. In other words, we assume that the consumer tries to maximize utility.”[1](Mansfield, Yohe: page 45) This applies to the purchase of a Camry in several ways. Let’s assume that a consumer wants to purchase a Camry and there are no incentive interest rate programs available. The consumer will then be subject to market rates. Assuming that the consumer qualifies for a Tier 1 rate, they will have a rate of 5.63 percent for 36 months, 5.9 percent for 48 or 60 months. [2]( the interest rate program were available, the consumer would have the opportunity to qualify for 1.9 percent. The difference in the interest rates would then have a subsequent change in the monthly payment. This difference could shift the consumer’s budget line to the left. Hence, the budget line would no longer be tangent to the consumer’s indifference curve if the rate were at 1.9 percent. Therefore, the consumer would not be able to attain consumer equilibrium. “…the market basket that would maximize the consumer’s utility is one that simultaneously lies on the budget line and on his or her highest feasible indifference curve.”(Mansfield, Yohe: page 50)[3] It can now be assumed that if a consumer cannot reach equilibrium with the Camry, they might consider the purchase of a new vehicle with inducement programs. This assumes that the consumer has a fixed income and the increase in monthly payment will adversely affect their indifference curve. This scenario also assumes that the Camry is the automobile which would offer a consumer the highest level of utility. Toyota has some motivation in offering these low interest rate programs. It allows them to sell more vehicles that might be out of reach for some consumers. The result has been phenomenal. The Toyota Camry has been the number one selling car for six out of the last seven years. Interest rate programs do not accomplish this feat alone. Product quality also plays a significant role, as the ownership costs for a Toyota Camry are some of the lowest in the class. Low ownership costs also help the consumer maximize their utility. This can be assumed because if a consumer knows that the Camry will be less expensive to own over a period of time, they might be willing to spend more on the vehicle causing a higher payment. Intellichoice.com stated that the Camry was “among the best for lowest ownership costs.”( higher payment is offset by the low interest rate and the competition against the Toyota Camry has its hands full.

Figure 2--Toyota Camry

Although sale price and interest rates play a major role in the purchasing decision of the consumer, it is also worth noting that there are other factors involved. Specifically, I would like to shift the focus to monetary policy. In a free market system, there are cyclical forces which have to be considered when looking at the behavior of the consumer. As the market system goes through a period of recession, it would appear that the consumption of goods and services would also decline. The Federal Reserve has the power, though, to affect consumer behavior with the implementation of monetary policy.

MostAmerican economists will tell you that the Federal Reserve did a brilliant job in preventing a deeper and longer recession after the stock market bubble burst. Monetary policy has certainly been successful at keeping up consumer spending, but it has been less good for jobs and incomes. America's non-farm payrolls have risen by only 0.5% since the trough of the recession in November 2001, the weakest jobs recovery on record. Private-sector wages and salaries have risen by only 2.8% in real terms, compared with an average gain of 10.6% in the six previous recoveries (see chart 12). Yet despite this, consumer spending over the same period has surged by 9%. Wages and salaries in America as a proportion of GDP are currently at their lowest level for decades, yet consumer spending relative to GDP is at a record high. The gap between income and spending has been financed partly by income-tax cuts, but also by saving less and by borrowing. Thanks to low interest rates the price of assets, especially homes, has risen steeply, which has made households feel richer and encouraged them to spend. This is happening not only in America but also in Britain, Australia, New Zealand, Spain and some smaller European economies. Household debt has jumped alarmingly. The great illusion,Economist, 00130613, 10/2/2004, Vol. 372, Issue 8395
Database: Business Source Premier

Through times of recession and wages that are not necessarily keeping up with the rate of inflation, consumers are able to attain a higher level of satisfaction because of low interest rates and the implementation of the Federal Reserve monetary policies.

The assumption that households borrow more and save less is significant in showing that consumers partially alter their purchasing decisions based on changes in nominal interest rates, as compared to the real interest rates. This is not only limited to durable good consumption, like a Camry, but non-durable goods are also subject to this condition. The nominal interest rate, which is not adjusted for inflation, has a powerful effect on the consumer, who is trying to maximize his or her utility. The real rate of interest is naturally a higher rate than its nominal counterpart. With this being said, it can be assumed that the consumer would be more restricted in their consumption behavior if the nominal rate was not taken into consideration.

Expenditures by consumers are generally thought to be affected by interest rates. In practice, econometric models have come to focus on the effects of expected, after-tax, real interest rates on households; purchases of durable goods. However, the empirical evidence presented here shows that interest rates have powerful effects on consumption, but they operate through nominal, not real, interest rates. Moreover, these nominal interest rate effects are not confined to spending for durables, but have equally important effects on spending on nondurables and services. These effects are presumed to arise because the household sector becomes increasingly borrowing-constrained as nominal interest rates rise and lenders impose limits on interest rate payments as a percent of income. Such liquidity constraints make consumer spending depend importantly on nominal interest rates and actual household cash flow. These facts are more easily measured and forecasted than the variables that theory and much practice suggest are relevant. (Wilcox, James a---Business Economics)

As you can see from the chart on the next page, figure 3, many consumers purchase automobiles, such as the Camry, at market rates. Interest rates and monetary policy are not the deciding factors in the purchasing decision of the consumer. In an effort to maximize ones’ utility, the attitudes and sentiment of the consumer factor into their assessment. “Consumer sentiment may predict future household spending, either because sentiment is an independent causal force or because it foreshadows current economic conditions. Consumer sentiment foreshadows current expectations about the economy as well as about interest rates, suggesting that it is useful as a barometer of the near-term outlook for spending.” (Mehra, Yash P.Martin, Elliot W. ,Economic Quarterly (Federal Reserve Bank of Richmond); Fall2003, Vol. 89 Issue 4, p51, 17p, 1 chart, 1 graph

The idea of consumer sentiment and the collection of data are significant because it could help explain consumer behavior utilizing a number of variables.

Business cycle analysts traditionally interpret consumer sentiment data as containing information about current and future consumer behaviour. One important attraction of these survey data is that they are readily available on a monthly basis. The evidence is mixed as to whether the information content of consumer sentiment can be captured by economic and financial variables such as interest rates, unemployment, stock market indices, etc. Vuchelen, Jef1 Journal of Economic Psychology; Aug2004, Vol. 25 Issue 4, p493, 14p

In conclusion, interest rates play a major role in the decision making process for the consumer. Although rates are a significant factor here, it can also be concluded that there are several other factors to be considered. Monetary policy, nominal interest rates and consumer sentiment are also a cause in the determination of the consumption behavior of the consumer.

Works Cited

Mansfield, Yohe. Microeconomics 11th ed. (New York: Norton)

Consumer Sentiment and Macroeconomic ForecastsVuchelen, Jef1 Journal of Economic Psychology; Aug2004, Vol. 25 Issue 4, p493, 14p

Why Does Consumer Sentiment Predict Household Spending? Mehra, Yash P.Martin, Elliot W. ,Economic Quarterly (Federal Reserve Bank of Richmond); Fall2003, Vol. 89 Issue 4, p51, 17p, 1 chart, 1 graph

The great illusion,Economist, 00130613, 10/2/2004, Vol. 372, Issue 8395
Database: Business Source Premier

Nominal Interest Rate Effects on Real Consumer Expenditure. Wilcox, James A. Business Economics, vol. 25, no.4, October 1990 pp. 31-37

CSA Internet Database Service

[1] This assumes the consumers preference for automobiles is the Camry

[2] Interest rates taken from

[3]This assumes that the consumer will maximize their utility with the purchase of the Camry