ch16 5e

Expectations,
Expectations,
Consumption,
Consumption,
and
and Investment
Investment
CHAPTER 16
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
Chapter 16: Expectations, Consumption, and Investment
16-1 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.
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16-1 Consumption
The Very Foresighted Consumer

A very foresighted consumer who decides how much to
consume based on the value of his total wealth, which
comprises:
1.
The value of his nonhuman wealth, or the sum of

financial wealth and housing wealth.
2.
The value of his human wealth and nonhuman

wealth together gives an estimate of his total
wealth.
Ct C (Totalwealth t )
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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. Among the many questions for which the Panel Study
of Income Dynamics (PSID) has been used are:
How much does (food) consumption respond to transitory
movements in incomefor example, to the loss of
income from becoming unemployed?
How much risk sharing is there within families? For
example, when a family member becomes sick or
unemployed, how much help does he or she get from
other family members?
How much do people care about staying geographically
close to their families?
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16-1 Consumption
An Example
Building on what you saw in Chapter 14, lets 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
Your wealth today, the expected value of your lifetime
after-tax labor income, is around $2 million.
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16-1 Consumption
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.
Ct C (Totalwealth t , YLT Tt )
Y
Lt
Tt
Y
LT
real labor income in year t.

real taxes in year t.
Tt
human wealth, or the expected

present value of after-tax labor income
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16-1 Consumption
Toward a More Realistic Description
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 of expected after-tax income.
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16-1 Consumption
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.
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Do People Save Enough for Retirement?
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
Home equity
65
Other equity
34
Total
$314
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16-1 Consumption
Putting Things Together: Current Income,

Expectations, and Consumption
This dependence of consumption on expectations has two
main implications for the relation between consumption and
income:
1.
Consumption is likely to respond less than one for

one to fluctuations in current income.
2.
Consumption may move even if current 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
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.
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16-2 Investment
Investment and Expectations of Profit
Depreciation
The depreciation rate, , measures how much usefulness
the machine from one year to the next.
Reasonable values for are between 4 and 15% for
machines, and between 2 and 4% for buildings and
factories.
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16-2 Investment
The Present Value of Expected Profits
V(et): The present value, in year t, of expected profit in

year t+1 equals:
1
e
1 rt
t 1
1
e
(1
In year t+2,
(1 rt )(1 r )
e
t 2
t 1
In year t,
1
1
e
V ( t )
(1 ) t 2
1 rt
(1 rt )(1 r )
e
t 1
t 1
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16-2 Investment
The Present Value of Expected Profits
Figure 16 - 1
Computing the Present
Value of Expected
Profits
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16-2 Investment
The Investment Decision

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:
I t I V te
( )
In words:
Investment depends positively on the expected present value
of future profits (per unit of capital). The higher the current or
expected profits, the higher the expected present value and
the higher the level of investment. The higher the current or
expected real interest rates, the lower the expected present
value, and thus the lower the level of investment.
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16-2 Investment
A Convenient Special Case
Suppose firms expect both future profits and future

interest rates to remain at the same level as today, so that
te1 te 2 ...= t
and
rt 1 rt 2 ...=rt
e
Economists call such expectations expectations that the

future will be like the present static expectations. Under
these two assumptions, we get
t
V ( t )
rt
e
16 of 27
Investment and the Stock Market
Tobins q denotes the variable corresponding to the value of a

unit of capital in place relative to its purchase price.
Figure 1
Tobins q versus the Ratio of Investment to Capital:

Annual Rates of Change, 1960 to 1999
17 of 27
16-2 Investment
A Convenient Special Case
t
Putting V ( ) r and I I [V ( )] together give

us an equation for investment:
e
It I
rt
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
18 of 27
16-2 Investment
Current versus Expected Profit
Some of the reasons we used to explain the behavior of

consumers also apply to firms:
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.
I I [V ( ), ]
e
(+,+)
In words: Investment depends both on the expected present
value of future profits and on the current level of profit.
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16-2 Investment
Current versus Expected Profit
Figure 16 - 2
Changes in Investment
and Changes in Profit in
the United States since
1960
Investment and profit move

very much together.
20 of 27
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.
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16-2 Investment
Profit and Sales
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 per unit of capital and the

ratio of output to capital move
largely together.
Yt

K t
(+)
22 of 27
16-3 The Volatility of Consumption

and Investment
Lets 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.
In the same way, whether firms perceive current
movements in sales to be transitory or permanent
affects their investment decisions.
23 of 27

and Investment
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.
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.
24 of 27

and Investment
Figure 16 - 4
Rates of Change of
Consumption and
Investment since 1960
Relative movements in
investment are much larger
than relative movements in
consumption.
25 of 27

and Investment
The figure yields three conclusions:

Consumption and investment usually
move together.
Investment is much more volatile than consumption.
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
permanent income theory
of consumption
life cycle theory of
consumption
financial wealth
housing wealth
human wealth
nonhuman wealth
total wealth
panel data sets
Tobins q
static expectations
user cost of capital, or
rental cost of capital
profitability
cash flow
27 of 27

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Expectations,

Chapter 16: Expectations, Consumption, and Investment

Chapter 16: Expectations, Consumption, and Investment

The Very Foresighted Consumer

The value of his nonhuman wealth, or the sum of

The value of his human wealth and nonhuman

Chapter 16: Expectations, Consumption, and Investment

Up Close and Personal: Learning from Panel Data Sets

Chapter 16: Expectations, Consumption, and Investment

Chapter 16: Expectations, Consumption, and Investment

Toward a More Realistic Description

real labor income in year t.

human wealth, or the expected

Chapter 16: Expectations, Consumption, and Investment

Expectations affect consumption in two ways:

Chapter 16: Expectations, Consumption, and Investment

Do People Save Enough for Retirement?

Mean Wealth of People, Age 65-69, in

Social Security Pension

Personal retirement assets

Other financial assets

Chapter 16: Expectations, Consumption, and Investment

Putting Things Together: Current Income,

Consumption is likely to respond less than one for

Consumption may move even if current income

Consumption may move even if current income does not due

Chapter 16: Expectations, Consumption, and Investment

Investment decisions depend on current sales, the current

Chapter 16: Expectations, Consumption, and Investment

Chapter 16: Expectations, Consumption, and Investment

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

Chapter 16: Expectations, Consumption, and Investment

Chapter 16: Expectations, Consumption, and Investment

The Investment Decision

Chapter 16: Expectations, Consumption, and Investment

Suppose firms expect both future profits and future

Economists call such expectations expectations that the

Investment and the Stock Market

Chapter 16: Expectations, Consumption, and Investment

Tobins q denotes the variable corresponding to the value of a

Tobins q versus the Ratio of Investment to Capital:

Putting V ( ) r and I I [V ( )] together give

Chapter 16: Expectations, Consumption, and Investment

Chapter 16: Expectations, Consumption, and Investment

Some of the reasons we used to explain the behavior of

But if current profit is high, the firm may not need to

borrowing. Potential lenders may not be convinced the

Chapter 16: Expectations, Consumption, and Investment

Investment and profit move

Chapter 16: Expectations, Consumption, and Investment

Profitability versus Cash Flow

Chapter 16: Expectations, Consumption, and Investment

Profit per unit of capital and the

16-3 The Volatility of Consumption

Chapter 16: Expectations, Consumption, and Investment

Lets look at the similarities between our treatment of

16-3 The Volatility of Consumption

Chapter 16: Expectations, Consumption, and Investment

But there are also important differences between