EC1B3

Macroeconomics I
Lent Term
Empirical evidence on
consumption
Consumption as a Random Walk
Random walk view of consumption
• Changes in consumption should be unpredictable.
• Due to unpredictable events such as a lottery win
or job loss
• Expected changes are planned for due to
permanent-income hypothesis.
• Due to predictable events such as expected salary
raise or new job.
Case Study: Consumption versus Expenditure
Key prediction of model:
• Consumption should not change when an
anticipated event occurs.
However, this doesn’t always hold true.
• Retirement
• Food expenditures decrease
• Calories consumed do not, though
Precautionary Saving
Precautionary saving
• Saving money just in case of an uncertain and
unpredictable event
• Can lead consumers to behave as if they face
borrowing constraints even if they don’t
• May even save when income is low
• Always a possibility of further income decreases
Empirical Evidence on Consumption
Does the evidence agree with the following
assumptions we’ve made?
Individuals with sufficient wealth
• Consumption may obey the permanent-income
hypothesis
• Follow a random walk
Individuals with low wealth or who cannot borrow
• Display much greater sensitivity to current income
Evidence from Individual Households—1
Three main findings:
The permanent-income hypothesis applies to
households with above-average wealth.
• The MPC out of a temporary income shock is low.
• Consumption smoothing is effective.
Low income households
• Behave as if borrowing-constrained
• Engage in precautionary saving
• MPC from income boost is high.
Evidence from Individual Households—2
Many departures from the classical model in the data
• Are individuals really rational?
Behavioral economics
• Research that blends psychology, neuroscience, and
economics
• Goal is to better understand how individuals make
economic decisions.
Case Study: Behavioral Economics and Consumption—1
Economic assumption
• People are rational.
But:
• What if people are bad at math?
• They are not irrational, but may make a “wrong”
decision.
Case Study: Behavioral Economics and Consumption—2
Behavioral considerations from 401(k) plans
• Participation is almost 100 percent when the
default is opt-in.
• Participation is less than 50 percent when
enrollment is not automatic.
Enron
• Employees did not diversify; the default retirement
option was Enron stock.
The default option is “sticky.”
Investment
Investment
Investment in macroeconomics
• In the sense of national income accounting
• Accumulation of physical capital
• Roads, houses, warehouses, tools
• Today’s investment influences future opportunities.
How Do Firms Make Investment Decisions?
How much should a business invest? Remember from Week 3 lecture:
• A business should keep investing in physical capital until 𝑀𝑃𝐾 = 𝑟

• MPK equals the rental price of capital.

• The rental rate of capital equals the real interest rate.

Reasoning with an Arbitrage Equation—1
Arbitrage equation:
• Two possible ways to invest money: put it in the bank vs buying new
capital
• If profits are maximized, the two investments must yield the same
return.

𝑟𝑝& = 𝑀𝑃𝐾 + Δ𝑝&

Reasoning with an Arbitrage Equation—2
For simplicity assume 𝑝!,# = 1. Then we can rearrange
the equation to get
Δ𝑝!
𝑀𝑃𝐾 = 𝑟 −
𝑝!
Invest in capital until the MPK equals the difference
between the real interest rate and the growth rate of
the price of capital.
If the price of capital is constant: 𝑀𝑃𝐾 = 𝑟
The User Cost of Capital—1
The growth rate in price =
• “Capital gain” if positive
• “Capital loss” if negative
Price of capital changes because of
• Depreciation, wear-and-tear
• Technological change
• particularly in electronics
• Scarce resources (structures)
The User Cost of Capital—2
Equation that includes depreciation

Δ𝑝!
𝑀𝑃𝐾 = 𝑟 + 𝑑 −
𝑝!

User cost of capital:

• Total cost to the firm of using one more unit of
capital
How Much Should a Firm Invest?

Marginal product
of capital, MPK

!"!
User Cost: 𝑟 + 𝑑 − "!
Example: Investment and the Corporate Income Tax
Adding a tax component (τ):
r

Rearranging:

r
An Increase in the Corporate Income Tax
From Desired Capital to Investment—1

n Production function

n Marginal product of capital

n Standard capital accumulation

From Desired Capital to Investment—2
Do some math on the MPK equation:

Rewrite capital accumulation equation:

Divide both sides by Kt:

From Desired Capital to Investment—3
Multiply and divide the first term on the right by

Sub in 3uc for Y/K, solve for investment rate:

From Desired Capital to Investment—4

The investment rate depends on three terms.

• The desired growth rate of capital stock
• The depreciation rate
• The user cost of capital
A higher user cost of capital leads to a lower
investment rate.
From Desired Capital to Investment—5
Key endogenous variables in the macroeconomy:
• Growth equations
• Pins down long-run growth rate
• Euler equation
• Pins down long-run real interest rate and user cost of capital
• MPK condition
• Pins down capital-output ratio
• Investment rate equation just found
• Pins down the investment rate and consumption share of GDP
The Stock Market and Financial Investment
“Capital” and “investment” are connected using the
arbitrage equation.
Finance investment options:
• Put money in savings account
• Earn interest
• Purchase a stock, sell a year later
• Pays a dividend
• Capital gains
The Arbitrage Equation and the Price of a Stock—1
Arbitrage equation (assuming safe investments)
r
Change in price
of stock
Divide both sides of the arbitrage equation by the
price of the stock.

r
Percentage
return in the
bank account
The Arbitrage Equation and the Price of a Stock—2
Solve for the price of stock:
• Group the bank return and capital gains
• Invert the equation

The price of a stock will equal the PDV of the dividends

the stock will pay.
P/E Ratios and Bubbles
The previous model does not take account for risk or
“bubbles” in the stock market.
We can find a price-earnings ratio by dividing the price
of stock by total earnings.
The Price-Earnings Ratio in the Stock Market
Efficient Markets—1
Informationally efficient market:
• Financial prices fully and correctly reflect all
available information.
• It’s impossible to make economic profits by trading
on basis of information.
• Theory states that only unexpected news moves
stock prices.
• Prices follow a random walk.
Efficient Markets—2
Mutual funds:
• Collections of stocks and assets in a large portfolio
• Small pieces sold off to investors
Types of mutual funds
• Actively managed
• Constant buying and selling
• Deliver high returns with low risk
• Higher fees
• Index funds
• Managed by a single computer program
• Designed to imitate major stock index
Efficient Markets—3
Efficient-markets benchmark is not the final word on
understanding financial markets.
• Some mutual funds beat the S&P index with more
persistence than predicted.
• More volatility in markets than justified by
fundamentals in model
• bubbles, for example
• may be explained by behavioral elements
Case Study: Tobin’s q, Physical Capital, and the Stock Market
James Tobin (Nobel Prize 1981)
• Model: The only asset a firm has is capital.
• Stock value of the firm is the value of its capital stock.
Consider adjustment costs in physical capital investment:
• The PDV of profits can differ from value of capital.
• With no adjustment costs, the firm should expand
immediately.
• With adjustment costs, expansion will occur gradually,
causing a difference in values.
Tobin’s q, Physical Capital, and the Stock Market—1
Tobin’s q

If q > 1
• Value of the firm is greater than the value of its capital.
• Firm should invest in more capital.
If q < 1
• Value of the firm is less than the value of its capital
• Firm should “disinvest.”
Tobin’s q, Physical Capital, and the Stock Market—2
Two basic predictions:
• Value of q should be close to 1.
• Value of q should be a useful predictor of firm investment.
In practice
• Prediction has problems:
• Some capital is created, patented, whereas other capital isn’t.
• Cash flow and access to loans seems to play a role, but are not
in the theory.
• Empirical evidence on the role of q is mixed.