Expectations

,
Consumption,
and Investment
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
cycle theory of consumption.
The Very Foresighted Consumer
 A very foresighted consumer who decide 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, or the present
value of expected after-tax labor income.
C C total weal
t
= ( ) th
t
Toward a More Realistic Description
 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.
C C total weal Y T
t LT t
= ÷ ( , ) th
t
Y T
LT t
÷ =
human wealth, or the expected present
value of after-tax labor income
T
t
=
real taxes in year t.
Y
Lt
=
real labor income in year t.

 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

 Educational attainment of the head of the family and its
members

 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:

 Engel’s Law (Ernst Engel)
 There is a relationship between the amount of income
and proportionate changes in consumption
expenditures 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.
Putting Things Together: Current Income,
Expectations, and 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 value of
nonhuman wealth is computed by financial
markets.
Putting Things Together: Current Income,
Expectations, and Consumption
 Consumption is likely to respond less than one
for one to fluctuations in current income.
 Consumption may decrease one for one with a
decrease in income only if the decrease in income is
considered to be permanent.
 Temporary changes in current income, such as those
caused by recessions and expansions, are unlikely to
increase consumption by as much as income.
 Consumption may move even if current income
does not due to changes in consumer
confidence.
Investment
 Gross Investment
= Net Investment + Depreciation
 Investment (flow variable)
 Durable equipment, new buildings, increase in
inventories
 Capital (stock variable)
 Equal to the amount of accumulated investment as
of a given point in time.
Investment
 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
buying it.
 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
Investment and Expectations of Profit
Depreciation:
 The rate of depreciation, measures how much
usefulness the machine loses from one year
to the next.
 Reasonable values are between 4 and 15%
for machines, and between 2 and 4% for
buildings and factories.
Investment and the Stock Market
 James Tobin argued that there should be a
tight relation between the stock market and
investment.
 The stock price tells firms how much the stock
market values each unit of capital already in
place; thus, the willingness to pay for one
more unit. If the stock market value exceeds
the purchase price, the firm should buy the
machine.
Profitability Versus Cash Flow
 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 together.
Profits and Sales
Changes in Profit and
Changes in the Ratio
of Output to Capital in
the United States,
1960-2000
H H
t
t
t
Y
K
=
|
\

|
.
|
Profit and the ratio of
output to capital move
largely together.
The Volatility of
Consumption and Investment
 Investment is more volatile than consumption.

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

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

or the sum of financial wealth and housing wealth. Ct  C(total wealtht ) . or the present value of expected after-tax labor income.The Very Foresighted Consumer  A very foresighted consumer who decide how much to consume based on the value of his total wealth.  The value of his human wealth. which comprises:  The value of his nonhuman wealth.

Ct  C(total wealtht . or the expected present value of after-tax labor income .  Consumption depends not only on total wealth but also on current income. YLT  Tt  human wealth. YLT  Tt ) YLt  real labor income in year t. Tt  real taxes in year t.Toward a More Realistic Description  The constant level of consumption that a consumer can afford equals his total wealth divided by his expected remaining life.

Shifts in the consumption function         Wealth Consumer and saving habits Size of the population Income distribution Credit availability Expectations of change in prices Expectations of future income Interest rates .

Determinants of family income:  Educational attainment of the head of the family and its members  Family size  Household Savings:  Income (permanent and transitory)  Interest rates  Exchange rates (real effective exchange rates) • Depreciation of the RUPEE • Appreciation of the RUPEE .

travel • Approximately the same percentage for rent. . amusement. Engel’s Law (Ernst Engel)  There is a relationship between the amount of income and proportionate changes in consumption expenditures as income level shifts. health. recreation.  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. fuel and light.

and Consumption  Expectations affect consumption in two ways:  Directly through human wealth. bonds. and taxes. or expectations of future labor income. and housing. Expectations.Putting Things Together: Current Income. . real interest rates. Expectations of the value of nonhuman wealth is computed by financial markets.  Indirectly through nonhuman wealth—stocks.

 Consumption may move even if current income does not due to changes in consumer confidence.Putting Things Together: Current Income.  Temporary changes in current income.  Consumption may decrease one for one with a decrease in income only if the decrease in income is considered to be permanent. are unlikely to increase consumption by as much as income. Expectations. such as those caused by recessions and expansions. and Consumption  Consumption is likely to respond less than one for one to fluctuations in current income. .

new buildings. .Investment  Gross Investment = Net Investment + Depreciation  Investment (flow variable)  Durable equipment. increase in inventories  Capital (stock variable)  Equal to the amount of accumulated investment as of a given point in time.

and on expectations of the future. the current real interest rate.  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 buying it. .Investment  Investment decisions depend on current sales.

 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 .

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

 The stock price tells firms how much the stock market values each unit of capital already in place. the firm should buy the machine. thus.Investment and the Stock Market  James Tobin argued that there should be a tight relation between the stock market and investment. the willingness to pay for one more unit. . If the stock market value exceeds the purchase price.

and are likely to move together. .  Cash flow refers to current profit.Profitability Versus Cash Flow  Profitability refers to the expected present discounted value of profits.  Both profitability and cash flow are important for investment decisions. or the net flow of cash the firm is receiving.

 Yt   t     Kt  .Profits and Sales Changes in Profit and Changes in the Ratio of Output to Capital in the United States. 1960-2000 Profit and the ratio of output to capital move largely together.

The Volatility of Consumption and Investment  Investment is more volatile than consumption.  Consumption and investment usually move together. Both components contribute roughly equally to fluctuations in output over time. .

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