05.Consumption and Investment

8/2/2019 05.Consumption and Investment

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Expectations,Consumption,

and Investment


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Consumption

The theory of consumption wasdeveloped by Milton Friedmanin the 1950s, who called it the

permanent income theory ofconsumption, and by FrancoModigliani, who called it the lifecycle theory of consumption.


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The Very Foresighted Consumer

A very foresighted consumer who decide howmuch to consume based on the value of histotal wealth, which comprises:

The value of his nonhuman wealth, or the sum offinancial wealthand housing wealth.

The value of his human wealth, or the presentvalue of expected after-tax labor income.

C C total wealt

( )tht


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Toward a More Realistic Description

The constant level of consumption that aconsumer can afford equals his total wealthdivided by his expected remaining life.

Consumption depends not only on total wealthbut also on current income.

C C total weal Y T t LT t

( , )tht

Y TLT t

human wealth, or the expected presentvalue of after-tax labor income

Tt

real taxes in year t.

YLt

real labor income in year t.


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Wealth

Consumer and saving habits

Size of the population

Income distribution

Credit availability

Expectations of change in prices

Expectations of future income

Interest rates

Shifts in the consumption function


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Educational attainment of the head of the family and itsmembers

Family size

Household Savings:

Income (permanent and transitory) Interest rates

Exchange rates (real effective exchange rates) Depreciation of the RUPEE Appreciation of the RUPEE

Determinants of family income:


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Engels Law (Ernst Engel)

There is a relationship between the amount of income

and proportionate changes in consumptionexpenditures as income level shifts.

As the income of the family increases:

A smaller percentage is spent for food

Approximately the same for clothing

Constantly increasing percentage spent for education, health,recreation, amusement, travel

Approximately the same percentage for rent, fuel and light.


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Putting Things Together: Current Income,Expectations, and Consumption

Expectations affect consumption in two ways:

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

Indirectly through nonhuman wealthstocks,bonds, and housing. Expectations of the value ofnonhuman wealth is computed by financialmarkets.


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Putting Things Together: Current Income,Expectations, and Consumption

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

Consumption may decrease one for one with a

decrease in income only if the decrease in income isconsidered to be permanent.

Temporary changes in current income, such as thosecaused by recessions and expansions, are unlikely to

increase consumption by as much as income.

Consumption may move even if current incomedoes not due to changes in consumerconfidence.


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Investment

Gross Investment

= Net Investment + Depreciation

Investment (flow variable)

Durable equipment, new buildings, increase ininventories

Capital (stock variable)

Equal to the amount of accumulated investment asof a given point in time.


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Investment

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

The decision to buy a machine depends on thepresent value of the profits the firm can expectfrom having this machine versus the cost of

buying it.


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Determinants of Investment: Business Investment in durable equipment

Rate of profit Interest rate

Changes in expectations

Rate of innovation

Rate of change in output

Inventory Investment Rate of increase in sales

Residential construction Change in income levels

Cost of construction Availability and cost of housing credit


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Investment and Expectations of Profit

Depreciation:

The rate of depreciation, measures how muchusefulness the machine loses from one yearto the next.

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

buildings and factories.


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Investment and the Stock Market

James Tobin argued that there should be atight relation between the stock market andinvestment.

The stock price tells firms how much the stockmarket values each unit of capital already inplace; thus, the willingness to pay for one

more unit. If the stock market value exceedsthe purchase price, the firm should buy themachine.


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Profitability Versus Cash Flow

Profitabilityrefers to the expected presentdiscounted value of profits.

Cash flowrefers to current profit, or the netflow of cash the firm is receiving.

Both profitability and cash flow are importantfor investment decisions, and are likely to

move together.


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Profits and Sales

Changes in Profit andChanges in the Ratioof Output to Capital inthe United States,

1960-2000

t

t

t

Y

K

Profit and the ratio ofoutput to capital movelargely together.


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The Volatility of

Consumption and Investment

Investment is more volatile than consumption.

Consumption and investment usually movetogether. Both components contribute roughlyequally to fluctuations in output over time.

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05.Consumption and Investment