Expectations,

Consumption,
and Investment

CHAPTER 16
CHAPTER16
Prepared by:
Fernando Quijano and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier

 16-1 Consumption
Chapter 16: Expectations, 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
and Investment

cycle theory of consumption.

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.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 2 of 26
 The Very Foresighted Consumer
Chapter 16: Expectations, Consumption,

A very foresighted consumer who decides how

much to consume based on the value of his total
wealth, which comprises:
The value of his nonhuman wealth, or the
sum of financial wealth and housing wealth.
The value of his human wealth and nonhuman
and Investment

wealth together gives an estimate of his total

wealth.
C t  C ( to ta l w e a lth t )

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 An Example
Chapter 16: Expectations, Consumption,

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.

V ( Y Le t  T t e )  ( $ 4 0 , 0 0 0 ) ( 0 . 7 5 ) ( 7 2 . 2 )  $ 2 , 1 6 6 , 0 0 0
and Investment

Your wealth today, the expected value of your

lifetime after-tax labor income, is around $2
million.

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 Toward a More Realistic Description
Chapter 16: Expectations, Consumption,

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.
and Investment

C t  C ( to ta l w e a lth t ,Y LT  Tt)

Y Lt  real labor income in year t.

T t  real taxes in year t.
Y L T  T t  human wealth, or the expected present
value of after-tax labor income
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 Toward a More Realistic Description
Chapter 16: Expectations, Consumption,

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
and Investment

of expected after-tax income.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 6 of 26

 Putting Things Together: Current Income,
Expectations, and Consumption
Chapter 16: Expectations, Consumption,

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
and Investment

value of nonhuman wealth is computed by

financial markets.

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 Do People Save Enough
for Retirement?
Chapter 16: Expectations, Consumption,

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
and Investment

Home equity $65

Other equity $34
Total $314

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 8 of 26

 Putting Things Together: Current Income,
Expectations, and Consumption
Chapter 16: Expectations, Consumption,

This dependence of consumption on

expectations has two main implications for the
relation between consumption and income:
 Consumption is likely to respond less than
one for one to fluctuations in current income.
 Consumption may move even if current
and Investment

income does not change.

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

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 16-2 Investment
Chapter 16: Expectations, Consumption,

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
and Investment

buying it.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 10 of 26

 Investment and Expectations of
Profit
Chapter 16: Expectations, Consumption,

Depreciation:
The rate of depreciation, , measures how much
usefulness the machine loses from one year to
the next.
Reasonable values for  are between 4 and 15%
for machines, and between 2 and 4% for
and Investment

buildings and factories.

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 The Present value of
Expected Profits
Chapter 16: Expectations, Consumption,

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

profit in year t+1 equals:

1
 e
t1
1  rt
and Investment

In year t+2, 1
(1   )  e
t2
(1  rt )(1  r e
t1 )
In year t,
1 1
V ( t) 
e
 e
t1 (1   )  e
t2  
1  rt (1  rt )(1  r e
t1 )
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 12 of 26
 The Present value of
Expected Profits
Chapter 16: Expectations, Consumption,

Figure 16 - 1
Computing the Present
Value of Expected
Profits
and Investment

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 The Investment Decision
Chapter 16: Expectations, Consumption,

Denote It as aggregate investment, t as profit

per machine (or per unit of capital) for the
economy as a whole, and V(et) as the expected
present value of profit per unit of capital. This
yields the investment function:
and Investment

I t  I (V (  e t ) )
( )
In words: Investment depends positively on the
expected present value of future profits (per unit
of capital).

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 A Convenient Special Case
Chapter 16: Expectations, Consumption,

Suppose firms expect both future profits and

future interest rates to remain at the same level
as today, so that  e   e
 
t1 t2 t

and r e
t1  r e
t2  rt
and Investment

Economists call such expectations –

expectations that the future will be like the
present –static expectations. Under these two
assumptions, we get  t
V (
e
t ) 
rt  
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 Investment and the
Stock Market
Chapter 16: Expectations, Consumption,

Figure 1
Tobin’s q.
Versus the Ratio
of Investment to
Capital: Annual
Rates of
Change, 1960-
1999
and Investment

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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 A Convenient Special Case
Chapter 16: Expectations, Consumption,

 t
Putting V (  ) 
e
t
rt   and I t  I ( V (  e
t ))
together give us an equation for investment:

  t 
It  I 
 rt   
and Investment

The sum of the real interest rate and the

depreciation rate is called the user cost or the
rental cost of capital.
Therefore,
Rental Cost  ( r t   )

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 Current Versus Expected Profit
Chapter 16: Expectations, Consumption,

Investment depends on expected future profit,

but also moves strongly with fluctuations in
current profit.
I t  I (V (  e t ) ,  t )
( , + )
and Investment

 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.
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 Current Versus Expected Profit
Chapter 16: Expectations, Consumption,

Figure 16 - 2
Changes in
Investment and
Changes in Profit in
the United States
since 1960

Investment and profit

move very much
and Investment

together.

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 Profitability Versus Cash
Flow
Chapter 16: Expectations, Consumption,

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
and Investment

together.

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 Profits and Sales
Chapter 16: Expectations, Consumption,

Figure 16 - 3
Changes in Profit
per Unit of Capital
Versus Changes in
the Ratio of Output
to Capital in the
United States since
1960

Profit and the ratio of

and Investment

output to capital
move largely
together.

 Yt 
    
t
 K t 
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 The Volatility of
16-3
Consumption and Investment
Chapter 16: Expectations, Consumption,

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.
and Investment

 In the same way, whether firms perceive

current movements in sales to be transitory or
permanent affects their investment decisions.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 22 of 26

 The Volatility of
Consumption and Investment
Chapter 16: Expectations, Consumption,

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.
and Investment

 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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 The Volatility of
Consumption and Investment
Chapter 16: Expectations, Consumption,

Figure 16 - 4
Rates of Change of
Consumption and
Investment since
1960

Relative movements
in investment are
much larger than
and Investment

relative movements in
consumption.

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 The Volatility of
Consumption and Investment
Chapter 16: Expectations, Consumption,

The figure yields three

conclusions:
 Consumption and
investment usually
move together.
 Investment is much
more volatile than
consumption.
and Investment

 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.

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 Key Terms
Chapter 16: Expectations, Consumption,

 permanent income theory of  nonhuman wealth

consumption  total wealth
 life cycle theory of  Tobin’s q
consumption  static expectations
 panel data sets  user cost of capital, or rental cost
 financial wealth of capital
 housing wealth  profitability
and Investment

 human wealth  cash flow

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 26 of 26