Macroeconomic Theory

Consumption cntd. and Investment

Nathaniel Cline

Agenda

1

Forward looking consumption

2

Investment

3

Review and To Do

Reminder: Exam on Thursday of Next Week

Covers:

  • National income and product

  • Employment

  • Inflation

  • Keynesian and Classical Approaches

  • Consumption

  • Investment

Quick Practice

\(C = 50 + 0.75Y_d\)

\(I = 150\)

  1. Construct the total demand function.

  2. What are the equilibrium levels of income, consumption, personal saving?

  3. Assume the income level is temporarily at $900 billion and explain the process whereby equilibrium is restored.

Some problems with the simple Keynesian consumption function

  • The Keynesian consumption function implies that the average propensity to consume:

\[ \frac{C}{Y_d} = \frac{c_0 + c_1Y_d}{Y_d} \]

\[ = \frac{c_0}{Y_d} + c_1 \]

  • 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

The role of interest rates?

  • 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

Why do people save?

  • 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

Life Cycle Savings

  • 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.

Stable consumption over a lifetime

  • 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 \(C_0\)

Resolving the puzzle

  • 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

Permanent income hypothesis

  • In a book published in 1957, Milton Friedman proposed the permanent-income hypothesis

\[ Y = Y^P + Y^T \]

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

Implications

  • 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.

Implications for the multiplier

  • 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

The Data

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

Durable goods tend to be very very volatile and closely related to short term income.

Three kinds of considerations:

  1. Real interest rate

  2. Credit availability

  3. Uncertainty about future income

Credit Rationing

  • 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

  • Stiglitz and Weiss (1981)
  • 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

    • Banks only lend to those who don’t need the money!
  • We will cover this in more detail later

Duesenberry

  • 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

In sum

We can say:

  • Consumers try to smooth consumption
  • Wealth matters

  • Access to credit matters

  • Consumption is still pretty closely related to current income.

Investment in the National Accounts

  • Investment in structures by private businesses

    • new non-residential and residential buildings, pipelines, railroad tracks, mines, etc…
  • Investment in equipment by private businesses

    • equipment with service life > 1 year (computers, machinery, forklifts, etc…)
  • Investment in software, R&D, and entertainment originals

    • this includes development and production of movies, TV, books, music
  • Investment in residential structures by owner occupants

  • Investment in structures and equipment and software by non-profit institutions

Inventories

  • 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

The Significance of Investment

  • 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

    • acquisition of capital goods which may enhance labor productivity and may also embody technology

What determines investment spending?

  • Focus for a minute on investment in structures, equipment, software and R&D by private businesses (business fixed investment)
  • Firms must consider:

    • cost of the investment
    • cost of obtaining funds
    • opportunity cost of funds
    • predictions of future prices and demand

And all of this occurs at different dates!

Expected income

  • Firms must not only predict the stream of future income

    • this expectation is precarious
  • The stream of income must also be valued in the present

The cost of investment

Two key costs:

  • costs of equipment

  • costs of funds

there are costs whether the funds come from internal reserves or external sources

Sources of Funds

  • 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

Present value

  • 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

Present value calculations

\[ PV = \frac{Payment_{t+1}}{(1+i)} + \frac{Payment_{t+2}}{(1+i)^2} + \frac{Payment_{t+3}}{(1+i)^3} \]

  • 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

The Interest Rate

  • 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

How Sensitive is Investment to Interest Rates?

  • 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

Why is investment not sensitive to interest rates?



We will answer this next time!

Review

Today we looked at some more complicated theories of consumption that argue consumers think about the future

  • we found that while that is likely true, they are limited in their ability to bring future income into the present

We also got an introduction to the data and some elements of the investment decision

  • we found that firms should respond to interest rates in theory, but don’t seem to in practice