© 2003 prentice hall business publishingmacroeconomics, 3/eolivier blanchard prepared by: fernando...

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

1616C H A P T E RC H A P T E R

Expectations,Expectations,Consumption,Consumption,and Investmentand Investment

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

ConsumptionConsumption16-1

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


The Very Foresighted ConsumerThe Very Foresighted Consumer

A very foresighted consumer who decide how A very foresighted consumer who decide how much to consume based on the value of his much to consume based on the value of his total wealthtotal wealth, which comprises:, which comprises: The value of his The value of his nonhuman wealthnonhuman wealth, or the sum of , or the sum of

financial wealthfinancial wealth and and housing wealthhousing wealth.. The value of his The value of his human wealthhuman wealth, or the present , or the present

value of expected after-tax labor income.value of expected after-tax labor income.

C C to ta l w ea lt ( )th t


Toward a More Realistic DescriptionToward a More Realistic Description

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

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

C C to ta l w ea l Y Tt L T t ( , )th t

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

Tt real taxes in year real taxes in year tt..

Y L t real labor income in year real labor income in year tt..


Toward a More Realistic DescriptionToward a More Realistic Description

Evidence on the relative importance of wealth Evidence on the relative importance of wealth and current income in consumption decisions and current income in consumption decisions shows that both affect consumption.shows that both affect consumption.

This evidence is gathered through This evidence is gathered through natural natural experimentsexperiments—experiments that economists —experiments that economists cannot control, but occur naturally.cannot control, but occur naturally.


Putting Things Together: Current Income, Putting Things Together: Current Income, Expectations, and ConsumptionExpectations, and Consumption

Expectations affect consumption in two ways:Expectations affect consumption in two ways: Directly through human wealth, or expectations of Directly through human wealth, or expectations of

future labor income, real interest rates, and taxes.future labor income, real interest rates, and taxes. Indirectly through nonhuman wealth—stocks, Indirectly through nonhuman wealth—stocks,

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


Putting Things Together: Current Income, Putting Things Together: Current Income, Expectations, and ConsumptionExpectations, and Consumption

Consumption is likely to respond less than one Consumption is likely to respond less than one for one to fluctuations in current income.for one to fluctuations in current income. Consumption may decrease one for one with a Consumption may decrease one for one with a

decrease in income only if the decrease in income is decrease in income only if the decrease in income is considered to be permanent.considered to be permanent.

Temporary changes in current income, such as those Temporary changes in current income, such as those caused by recessions and expansions, are unlikely to caused by recessions and expansions, are unlikely to increase consumption by as much as income.increase consumption by as much as income.

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


InvestmentInvestment16-2

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

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


Investment and Expectations of ProfitInvestment and Expectations of Profit

DepreciationDepreciation:: The rate of depreciation, The rate of depreciation, , measures how , measures how

much usefulness the machine loses from one much usefulness the machine loses from one year to the next.year to the next.

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



The Present Value of Expected Profits, V(The Present Value of Expected Profits, V(eett):):

The present value, in year The present value, in year tt, of expected profit , of expected profit in year in year t+1t+1 equals: equals: 1

11

rt

et

In year In year tt+2,+2,

Vr r r

et

t

et

te

t

et( )

( )( )( )

1

1

1

1 111

12

In year t,In year t,

1

1 11

12

( )( )( )

r rte

t

et



Computing the Present Computing the Present Value of Expected Value of Expected ProfitsProfits


The Investment DecisionThe Investment Decision

Denote Denote IItt as aggregate investment, as aggregate investment, tt as profit as profit

per machine (or per unit of capital) for the per machine (or per unit of capital) for the economy as a whole, and V(economy as a whole, and V(ee

tt) as the ) as the

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

I I Vte

t ( ( ))( )

In words, investment depends positively on the expected In words, investment depends positively on the expected present value of future profits (per unit of capital).present value of future profits (per unit of capital).


Investment and the Stock MarketInvestment and the Stock Market

James Tobin argued that there should be a James Tobin argued that there should be a tight relation between the stock market and tight relation between the stock market and investment.investment.

The stock price tells firms how much the stock The stock price tells firms how much the stock market values each unit of capital already in market values each unit of capital already in place; thus, the willingness to pay for one place; thus, the willingness to pay for one more unit. If the stock market value exceeds more unit. If the stock market value exceeds the purchase price, the firm should buy the the purchase price, the firm should buy the machine.machine.


Investment and the Stock MarketInvestment and the Stock Market

The stock market value of U.S. corporations The stock market value of U.S. corporations (share price times number of shares) divided (share price times number of shares) divided by the value of the capital stock of U.S. by the value of the capital stock of U.S. corporations is called corporations is called Tobin’s Tobin’s qq..

This ratio gives the value of a unit of capital This ratio gives the value of a unit of capital relative to its current purchase price. The relative to its current purchase price. The higher the value of capital relative to its higher the value of capital relative to its current purchase price, the higher should be current purchase price, the higher should be investment.investment.



Tobin’s q Versus the Tobin’s q Versus the Ratio of Investment to Ratio of Investment to Capital—Annual Rates Capital—Annual Rates of Change, 1960-1999of Change, 1960-1999

There is a tight relation between investment and the value of the stock market.


A Convenient Special CaseA Convenient Special Case

Assume that:Assume that: Future profits and future interest rates remain the Future profits and future interest rates remain the

same as today, andsame as today, and People have People have static expectationsstatic expectations (expect the (expect the

future to be like the present).future to be like the present).

Under these assumptions, the equationUnder these assumptions, the equation

becomes:becomes:

Vr r r

et

t

et

te

t

et( )

( )( )( )

1

1

1

1 111

12

( )e

tt

tr


A Convenient Special CaseA Convenient Special Case

Investment is a function of the ratio of the Investment is a function of the ratio of the profit per unit of capital to the sum of the real profit per unit of capital to the sum of the real interest rate and the depreciation rate.interest rate and the depreciation rate.

The term is called the The term is called the user cost or the user cost or the rental cost of capitalrental cost of capital..

I I Vte

t ( ( ))( )e

tt

tr

GivenGiven andand then,then,

I Irt

t

t

rt


Current Versus Expected ProfitCurrent Versus Expected Profit

Investment depends on expected future profit, Investment depends on expected future profit, but also moves strongly with fluctuations in but also moves strongly with fluctuations in current profit.current profit.

I I Vte

t t ( ( ), ) ( , ) +

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



Changes in Changes in Investment and Investment and Changes in Profit in Changes in Profit in the United States, the United States, 1960-20001960-2000

Investment and profit move very much together.


Profitability Versus Cash FlowProfitability Versus Cash Flow

ProfitabilityProfitability refers to the expected present refers to the expected present discounted value of profits.discounted value of profits.

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

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


Profits and SalesProfits and Sales

Changes in Profit and Changes in Profit and Changes in the Ratio Changes in the Ratio of Output to Capital in of Output to Capital in the United States, the United States, 1960-20001960-2000

tt

t

Y

K

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


The Volatility ofThe Volatility ofConsumption and InvestmentConsumption and Investment

16-3

Investment is more volatile than consumption. Investment is more volatile than consumption. Consumers do not increase consumption more Consumers do not increase consumption more than one for one with increases in income. than one for one with increases in income. Investment, on the other hand, may exceed an Investment, on the other hand, may exceed an increase in current sales.increase in current sales.

Consumption and investment usually move Consumption and investment usually move together. Both components contribute roughly together. Both components contribute roughly equally to fluctuations in output over time.equally to fluctuations in output over time.


The Volatility ofThe Volatility ofConsumption and InvestmentConsumption and Investment

Rates of Change of Rates of Change of Consumption and Consumption and Investment, 1960-Investment, 1960-20002000

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


Key TermsKey Terms

permanent income theory of conpermanent income theory of consumption,sumption,

life cycle theory of consumption,life cycle theory of consumption, financial wealth,financial wealth, housing wealth,housing wealth, human wealth,human wealth, nonhuman wealth,nonhuman wealth,

total wealth, natural experiment, Tobin’s q, static expectations, user cost of capital, or rental c

ost of capital, profitability, cash flow,

© 2003 prentice hall business publishingmacroeconomics, 3/eolivier blanchard prepared by: fernando...

Documents