Consumption cntd. and Investment
1
Forward looking consumption
2
Investment
3
Review and To Do
Covers:
National income and product
Employment
Inflation
Keynesian and Classical Approaches
Consumption
Investment
\(C = 50 + 0.75Y_d\)
\(I = 150\)
Construct the total demand function.
What are the equilibrium levels of income, consumption, personal saving?
Assume the income level is temporarily at $900 billion and explain the process whereby equilibrium is restored.
\[ \frac{C}{Y_d} = \frac{c_0 + c_1Y_d}{Y_d} \]
\[ = \frac{c_0}{Y_d} + c_1 \]
So that as income rises, consumption becomes a declining share of total income
But as you have seen in your homeworks, consumption is a roughly constant (and recently increasing!) share of total income
As we saw earlier, the classical theorists thought that interest rates played a big role in decisions to save and therefore consume.
But the interest rate plays no role in the Keynesian story
People save because they think they will need money in the future
Macroeconomists often think of the decision to save as a decision to consume later
though there are some issues with this
Some economists have thus argued that consumption should in general depend on a consumers vision of the future
In a series of papers in the 1950s Franco Modigliani argued for a life cycle style consumption function
Saving allows consumers to move income from those times in life when income is high to those times when it is low.
Most people plan to stop working at about age 65, and they expect their incomes to fall when they retire. To maintain consumption, people must save during their working years.
Suppose a consumer expects to live another T years, has wealth of W, and expects to earn income Y per year until he retires R years from now.
lifetime resources are composed of initial wealth \(W\) and lifetime earnings \(R \times Y\)
\[ C = \frac{W+RY}{T}\]
\[ C = (1/T)W + (R/T)Y \]
If all consumers do this, aggregate income looks like:
\[ C = \alpha W + \beta Y \] in other words, wealth is now our \(C_0\)
While income increases in the short run, sure higher income corresponds to a lower average propensity to consumer
Over the long run though, income grows wealth, which shifts the consumption function up
\[ Y = Y^P + Y^T \]
Where \(Y^P\) is permanent income, and \(Y^T\) are transitory fluctuations in income
Friedman argued that permanent income will have much larger influence than transitory
According to the permanent-income hypothesis, the average propensity to consume depends on the ratio of permanent income to current income.
When current income temporarily rises above permanent income, the average propensity to consume temporarily falls; when current income temporarily falls below permanent income, the average propensity to consume temporarily rises.
Future oriented theories of consumption imply that government stimulus may not be as effective as the Keynesians suggested
In particular, if a tax cut or increase in government spending is a short term even (like stimulus checks), it will be primarily saved because it does not increase lifetime income
But it does imply that financial markets could play a big role in consumption
In practice consumption seems to be more volatile and more closely related to short term changes in income than future oriented theories predict.
Why?
Durable goods tend to be very very volatile and closely related to short term income.
Three kinds of considerations:
Real interest rate
Credit availability
Uncertainty about future income
But even non-durables are more sensitive than we would expect.
One reason is that households must have large prior wealth, or access to credit to smooth consumption
Many households do not have stocks of wealth, and even more importantly, credit is often rationed
In part this is because of imperfect information
Credit rationing occurs when people are unable to obtain funds at the relevant market rate of interest
Imperfect information may lead to demands for equity or collateral from borrowers
We will cover this in more detail later
As you read, Duesnberry had an alternative explanation to Friedman and others
If the rich save at higher rates than poor, why doesn’t saving rise as everyone becomes richer?
Duesenberry’s explanation of the discrepancy is that poverty is relative. The poor save at lower rates, he argued, because the higher spending of others kindles aspirations they find difficult to meet.
Duesenberry argued that families look not only to the living standards of others, but also to their own past experience
We can say:
Wealth matters
Access to credit matters
Consumption is still pretty closely related to current income.
Investment in structures by private businesses
Investment in equipment by private businesses
Investment in software, R&D, and entertainment originals
Investment in residential structures by owner occupants
Investment in structures and equipment and software by non-profit institutions
changes in inventories are included in total investment in the NIPA accounts
Finished/ready for sale goods
work in process inventory
materials and supplies inventory
These are included in total income/gdp, but NOT in total demand
Investment is one of the most volatile components of spending (along with consumer durables) so may be key to understanding business cycles
Investment also impacts long run productivity of the economy
Firms must consider:
And all of this occurs at different dates!
Firms must not only predict the stream of future income
The stream of income must also be valued in the present
Two key costs:
costs of equipment
costs of funds
there are costs whether the funds come from internal reserves or external sources
Retained earnings
Borrowing via bank loans
Borrowing via other debt instruments
Selling new equity shares
Borrowing sets up a stream of cash payments that legally need to be met
Any investment calculation involves understanding the present value of a future stream of payments
$100 due in one year is worth less than $100 today… but how much less?
How much would you have to pay me in one year to get me to give up $100 today? $110? $120?
The answer is the rate of interest
\[ PV = \frac{Payment_{t+1}}{(1+i)} + \frac{Payment_{t+2}}{(1+i)^2} + \frac{Payment_{t+3}}{(1+i)^3} \]
where \(i\) is the risk free rate of interest that you could get by loaning the money out
we would also want to modify this for the degree of risk/uncertainty
a firm can then compare the cost of funds to the expected present value of an investment good
It is common in macroeconomics courses to suggest that investment spending is inversely related to “the” rate of interest
As “the” rate of interest rises, both the cost of borrowing AND the opportunity cost of retained earnings rises
When compared with the present value of investment projects, this means that some projects will no longer have a present value that exceeds the cost of funds
a common finding empirically however is that investment is not particularly interest elastic
Gormsen and Huber (2022) combed through “earnings calls” and flagged any mention of the hurdle rate or required return on new capital projects.
Hurdle rates are the minimum rate of return a business requires to undertake an investment project
They found that the hurdle rates were very high (15-20%) and did not seem to move with current interest rates
alternatively, housing investment (particularly by individuals) does seem to be fairly interest sensitive
We will answer this next time!
Today we looked at some more complicated theories of consumption that argue consumers think about the future
We also got an introduction to the data and some elements of the investment decision