chapter 16 expectations, consumption, and investment expectations, consumption, and investment...

CHAPTER 16

Expectations, Consumption,and Investment

Expectations,Consumption,and Investment

CHAPTER 16

Prepared by:

Fernando Quijano and Yvonn Quijano

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 27

16-1 Consumption

The theory of consumption was developed by Milton Friedman in the 1950s, who called it the permanent income theory of consumption, and by Franco Modigliani, who called it the life cycle theory of consumption.

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16-1 Consumption

The Very Foresighted Consumer

A very foresighted consumer who decides how much to consume based on the value of his total wealth, which comprises:

1. The value of his nonhuman wealth, or the sum of financial wealth and housing wealth.

2. The value of his human wealth and nonhuman wealth together gives an estimate of his total wealth.

( )Total wealtht tC C

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Up Close and Personal: Learning from Panel Data Sets

Panel data sets are data sets that show the value of one or more variables for many individuals or many firms over time. Among the many questions for which the Panel Study of Income Dynamics (PSID) has been used are:

How much does (food) consumption respond to transitory movements in income—for example, to the loss of

income from becoming unemployed?

How much risk sharing is there within families? For example, when a family member becomes sick or unemployed, how much help does he or she get from other family members?

How much do people care about staying geographically close to their families?

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Building on what you saw in Chapter 14, let’s compute the present value of your labor income as the value of real expected after-tax labor income, discounted using real interest rates.

Your wealth today, the expected value of your lifetime after-tax labor income, is around $2 million.

V Y TL te

te( ) ($ 4 0 , )( . )( . ) $ 2 , , 0 0 0 0 7 5 7 2 2 1 6 6 0 0 0

16-1 Consumption

An Example

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The constant level of consumption that a consumer can afford equals his total wealth divided by his expected remaining life.

Consumption depends not only on total wealth but also on current income.

( , )Total wealtht t LT tC C Y T

Y TLT t human wealth, or the expected present value of after-tax labor income

Tt real taxes in year t.

Y L t real labor income in year t.

16-1 Consumption

Toward a More Realistic Description

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In words:

Consumption is an increasing function of total wealth, and also an increasing function after-tax labor income. Total wealth is the sum of nonhuman wealth – financial wealth plus housing wealth – and human wealth – the present value of expected after-tax income.

16-1 Consumption

Toward a More Realistic Description

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Expectations affect consumption in two ways:

Directly through human wealth, or expectations of future labor income, real interest rates, and taxes.

Indirectly through nonhuman wealth - stocks, bonds, and housing. Expectations of the value of nonhuman wealth is computed by financial markets.

16-1 Consumption

Putting Things Together: Current Income, Expectations, and Consumption

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Do People Save Enough for Retirement?

Table 1 Mean Wealth of People, Age 65-69, in 1991 (in thousands of 1991 dollars)

Social Security Pension $100

Employer-provided pension 62

Personal retirement assets 11

Other financial assets 42

Home equity 65

Other equity 34

Total $314

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This dependence of consumption on expectations has two main implications for the relation between consumption and income:

1. Consumption is likely to respond less than one for one to fluctuations in current income.

2. Consumption may move even if current income does not change.

Consumption may move even if current income does not due to changes in consumer confidence.

16-1 Consumption

Putting Things Together: Current Income, Expectations, and Consumption

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Investment decisions depend on current sales, the current real interest rate, and on expectations of the future.

The decision to buy a machine depends on the present value of the profits the firm can expect from having this machine versus the cost of buying it.

16-2 Investment

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16-2 Investment

Investment and Expectations of Profit

The depreciation rate, , measures how much usefulness the machine from one year to the next.

Reasonable values for are between 4 and 15% for machines, and between 2 and 4% for buildings and factories.

Depreciation

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V(et): The present value, in year t, of expected profit in

year t+1 equals:

1

1

1 t

e

tr

In year t+2,

1

1

2

1 1( ) (1 )

1 (1 )(1 )

e

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t

e e

t t

t t

Vr r r

In year t,

2

1

1(1 )

(1 )(1 )e

t

t

e

tr r

16-2 Investment

The Present Value of Expected Profits

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16-2 Investment

The Present Value of Expected Profits

Computing the Present Value of Expected Profits

Figure 16 - 1

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16-2 Investment

Denote It as aggregate investment, t as profit per machine (or per unit of capital) for the economy as a whole, and V(e

t) as the expected present value of profit per unit of capital. This yields the investment function:

In words:

Investment depends positively on the expected present value of future profits (per unit of capital). The higher the current or expected profits, the higher the expected present value and the higher the level of investment. The higher the current or expected real interest rates, the lower the expected present value, and thus the lower the level of investment.

The Investment Decision

( ) et t

I I V

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Economists call such expectations – expectations that the future will be like the present –static expectations. Under these two assumptions, we get

Suppose firms expect both future profits and future interest rates to remain at the same level as today, so that

1 2 ... = e e

t t t

1 2 ... = e e

t t tr r r

( )e t

t

t

Vr

and

16-2 Investment

A Convenient Special Case

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Investment and the Stock Market

Figure 1 Tobin’s q versus the Ratio of Investment to Capital: Annual Rates of Change, 1960 to 1999

Tobin’s q denotes the variable corresponding to the value of a unit of capital in place relative to its purchase price.

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Putting and together give us an equation for investment:

( )e

t

t

t

Vr

[ ( )]

e

t tI I V

I Irt

t

t

The sum of the real interest rate and the depreciation rate is called the user cost or the rental cost of capital.

Therefore:

( )tr Rental Cost =

16-2 Investment

A Convenient Special Case

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In words: Investment depends both on the expected present value of future profits and on the current level of profit.

[ ( ), ]

( + , + )

e

tt tI I V

Firms may be reluctant to borrow if current profit is low. But if current profit is high, the firm may not need to borrow to finance its investments.

Even if the firm wants to invest, it might have difficulty

borrowing. Potential lenders may not be convinced the project is as good as the firms says.

16-2 Investment

Current versus Expected Profit

Some of the reasons we used to explain the behavior of consumers also apply to firms:

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16-2 Investment

Current versus Expected Profit

Investment and profit move very much together.

Changes in Investment and Changes in Profit in the United States since 1960

Figure 16 - 2

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Profitability versus Cash Flow

Profitability refers to the expected present discounted value of profits.

Cash flow refers to current profit, or the net flow of cash the firm is receiving.

Both profitability and cash flow are important for investment decisions, and are likely to move together.

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16-2 Investment

Profit and Sales

tt

t

Y

K

( + )

Profit per unit of capital and the ratio of output to capital move largely together.

Changes in Profit per Unit of Capital versus Changes in the Ratio of Output to Capital in the United States since 1960

Figure 16 - 3

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Let’s look at the similarities between our treatment of consumption and of investment behavior:

Whether consumers perceive current movements in income to be transitory or permanent affects their consumption decisions.

In the same way, whether firms perceive current movements in sales to be transitory or permanent affects their investment decisions.

16-3 The Volatility of Consumptionand Investment

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But there are also important differences between consumption decisions and investment decisions:

When faced with an increase in income that consumers perceive as permanent, they respond with at most an equal increase in consumption.

When firms are faced with an increase in sales they believe to be permanent, their present value of expected profits increases, leading to an increase in investment.


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Relative movements in investment are much larger than relative movements in consumption.

Rates of Change of Consumption and Investment since 1960

Figure 16 - 4

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The figure yields three conclusions:

Consumption and investment usually move together.

Investment is much more volatile than consumption.

Because, however, the level of investment is much smaller than the level of consumption, changes in investment from one year to the next end up being of the same overall magnitude as changes in consumption.

chapter 16 expectations, consumption, and investment expectations, consumption, and investment...

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