Ch 19

The Microfoundations of Consumption

and Investment
John Maynard Keynes (1936) and the Consumption Function

Keynes’s Conjectures
• First: Marginal propensity to consume  to increase their consumption as their
income increases, but not by as much as the increase in their income.
• The power of fiscal policy to influence the economy—as expressed by the fiscal-policy
multipliers—arises from the feedback between income and consumption.
• Second, Keynes posited that the ratio of consumption to income, called the
average propensity to consume, falls as income rises.
• He believed that saving was a luxury, so he expected the rich to save a higher proportion of
their income than the poor
• Third, Keynes thought that income is the primary determinant of consumption
and that the interest rate does not have an important role.
• Not like classical economy  Higher i means higher saving, Keynes believe that the short-
period influence of the rate of interest on individual spending out of a given income is
secondary and relatively unimportant.”
In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of these seemingly
contradictory findings. Both economists later won Nobel Prizes, in part for their work on consumption.
Modigliani and Friedman started with the same insight: If people prefer consumption to be smooth year to
year rather than widely fluctuating, they should be forward-looking. Their spending should depend not
only on their current income but also on the income they expect to receive in the future. But the two
economists took this insight in different directions.
 Franco Modigliani (1950s) and the Life-Cycle
Hypothesis

• People will retire, and they don’t want they income to suddenly drop 
saving.
• C=(W+RY)/T  Suppose a consumer expects to live another T years, has
wealth of W, and expects to earn income Y per year until she retires R years
from now.  C=(1/T)W+(R/T)Y
• For example, if the consumer expects to live for 50 more years and work for
30 of them, then T=50 and R=30,
C=0.02W+0.6Y.
• Aggregate Population : C=aW+ßY, where the parameter alpha is the marginal
propensity to consume out of wealth and the parameter ß is the marginal
propensity to consume out of income.
 Milton Friedman (1957) and the Permanent-Income
Hypothesis

• Friedman’s permanent-income hypothesis complements Modigliani’s

life-cycle hypothesis: both argue that consumption should not depend
on current income alone.
• But unlike the life-cycle hypothesis, which emphasizes that income
follows a regular pattern over a person’s lifetime, the permanent
income hypothesis emphasizes that people experience random
changes In their Incomes from year to year.
The Hypothesis

• Permanent income is the part of income that people expect to persist

into the future. Transitory income is the part of income that people
do not expect to persist. Put differently, permanent income is average
income, and transitory income is the random deviation from that
average.  Y=YP+Yt
• Example: Good education  permanently higher income. Farmers,
depend on weather  Temporary income.
• Consumers spend their permanent income, but they save most of
their transitory income.
Robert Hall and the Random-Walk Hypothesis
The Hypothesis
• The rational-expectations assumption : that people use all available information to make optimal
forecasts about the future.
• He showed that if the permanent-income hypothesis is correct, and if consumers have rational
expectations, then changes in consumption over time should be unpredictable.
• The combination of the permanent-income hypothesis and rational expectations implies that
consumption follows a random walk.
• Permanent-income hypothesis: Smooth consumption. But at one point, their expectation will
determine their consumption. Promotions, demotions, new job, will be unpredictable.
• If consumers obey the permanent-income hypothesis and have rational expectations, only
unexpected policy changes influence consumption. These policy changes take effect when they
change expectations.
David Laibson and the Pull of Instant Gratification

• Keynes: Consumption function as a “fundamental psychological law”.

• Friedman, Modigliani, Hall : not psychology, but consumers are utility maximizers.
• Laibson: Behavioral economics, the insufficiency of saving is related to another phenomenon: the
pull of instant gratification.
• Question 1: Would you prefer (A) a candy today or (B) two candies tomorrow?
• Question 2: Would you prefer (A) a candy in 100 days or (B) two candies in 101 days?
• Orang akan jawab A di nomor 1 dan B di nomor 2, karena di short run, mereka ingin
menikmatinya cepat, sedangkan di long run, mereka mau nunggu sehari lagi.
• That happens in everyday life. Time-inconsistent preference.
• Same as a promise to quit cigarette, reduce shopping, or eat sugars, people will say: I will have
some today, and have less tomorrow. But TOMORROW NEVER COMES..!!
The Bottom Line on Consumption

Economists debate the importance of these determinants of consumption. There remains disagreement about, for
example, the influence of interest rates on consumer spending, the prevalence of borrowing constraints, and the
importance of psychological effects. Economists sometimes disagree about economic policy because they
assume different consumption functions.
19-2 What Determines Investment Spending?

• Investment is the component of GDP that links the present and the future.
• There are three types of investment spending: business fixed investment (about
¾ of total investment), residential investment, and inventory investment.
• Business=firms, fixed=long-term (as opposed to inventory).
• The standard model of business fixed investment is called the neoclassical model
of investment: examines the benefits (marginal product) and costs (interests and
taxes) to firms of owning capital goods.
• For simplicity: Imagine there are two types of firms: Producers (only produce
goods and services, using rented capital), Rental Firms (invest and rent it out).
The Rental Price of Capital

• Rental rate R, and price P: real cost of unit production R/P.

• MPK : Marginal Product of Capital  max at MPK = R/P.
• Contoh: Harga Sewa Rp 1 juta, produksi 1 juta unit.
• Price = Rp 5/unit. MPK = apabila tambahan 1 mesin hanya menambah Rp 1 juta / Rp 5 = 200.000 unit.
• Cobb-Douglas:

• This expression identifies the variables that determine the real rental price. It shows the
following:
• The lower the capital stock, the higher the real rental price of capital.
• The greater the amount of labor employed, the higher the real rental price of capital.
• The better the technology, the higher the real rental price of capital.
The Cost of Capital

The cost of owning capital is more complex. For each period of time that it rents out a unit of capital, the rental
firm bears three costs:
1. Make loan to buy capital  PK = purchase price of a unit of capital  iPK is the interest cost (assume that if buy
with cash, they will lose i on bank deposits equally).

2. While the rental firm is renting out the capital, the price of capital can change. If the price of capital falls, the
firm loses because the firm’s asset has fallen in value. If the price of capital rises, the firm gains because the firm’s
asset has risen in value. The cost of this loss or gain is -ΔPK (The minus sign is here because we are measuring
costs, not benefits.)

3. While the capital is rented out, it suffers wear and tear, called depreciation. If is the rate of depreciation—
the fraction of capital’s value lost per period because of wear and tear—then the dollar cost of depreciation is PK

Example: Price=30,000; i = 10%, prise rise = 6% per year, Depreciation 20% / year:
 r = real interest rate  (i minus inflation)

This equation states that the cost of capital depends on the price of capital, the real interest rate, and the
depreciation rate.

The real cost of capital—the cost of buying and renting out a unit of capital measured in units of the economy’s
output—is
Taxes and Investment tax credit

• The corporate income tax is a tax on corporate profits.

• The effect of a corporate income tax on investment depends on how
the tax law defines “profit.”
• Tax laws calculate depreciation by using historical cost, while our
definition of cost of capital, use current value.
• Investment tax credit  used as incentive to encourage investment.
 The Stock Market and Tobin’s q

• The Nobel Prize–winning economist James Tobin proposed that firms base their
investment decisions on the following ratio, now called Tobin’s q:
q=Market Value of Installed Capital / Replacement Cost of Installed Capital
• The numerator of Tobin’s q is the value of the economy’s capital, as determined by the
stock market. The denominator is the price of that capital if it were purchased today.
• Invest if q > 1.
• If q is greater than 1, the stock market values installed capital at more than its
replacement cost. In this case, managers can raise the market value of their firms’ stock
by buying more capital.
• The advantage of Tobin’s q as a measure of the incentive to invest is that it reflects the
expected future profitability of capital as well as the current profitability.
Financing Constraints

• When a firm wants to invest in new capital—say, by building a new factory—it

often raises the necessary funds in financial markets: obtaining loans from banks,
selling bonds to the public, or selling shares in future profits on the stock market.
The neoclassical model assumes that if a firm is willing to pay the cost of capital,
the financial markets will make the funds available.
• Yet sometimes firms face financing constraints—limits on the amount they can
raise in financial markets  prevent firms from undertaking profitable
investments.
The Bottom Line on Investment
• First, investment spending is inversely related to the real interest rate because a higher
interest rate raises the cost of capital. Thus, the neoclassical model of investment justifies
the investment function we have used throughout this book.
• Second, various events can shift the investment function. An improvement in the
available technology raises the marginal product of capital and raises investment. Various
policies, such as changes in the corporate income tax, alter the incentives to invest and
thus shift the investment function.
• Third, investment will naturally be volatile over the business cycle because investment
spending depends on the state of the economy as well as on the interest rate. In the
neoclassical model of investment, higher employment raises the marginal product of
capital and the incentive to invest. Higher output also raises firms’ profits and, thereby,
relaxes the financing constraints that some firms face. Our analysis predicts that an
economic boom should stimulate investment, and a recession should depress it. This is
exactly what we observe.
THANK YOU