Expectations,Expectations,Consumption,Consumption,and Investmentand Investment

ConsumptionConsumption The theory of consumption was The theory of consumption was

developed by Milton Friedman developed by Milton Friedman in the 1950s, who called it the in the 1950s, who called it the permanent income theory of permanent income theory of consumptionconsumption, and by Franco , and by Franco Modigliani, who called it the Modigliani, who called it the life life cycle theory of consumptioncycle theory of consumption..

The Very Foresighted ConsumerThe Very Foresighted Consumer

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

financial wealthfinancial wealth and and housing wealthhousing wealth.. The value of his The value of his human wealthhuman wealth, or the present , or the present

value of expected after-tax labor income.value of expected after-tax labor income.

C C to ta l w ea lt ( )th t

Toward a More Realistic DescriptionToward a More Realistic Description

The constant level of consumption that a The constant level of consumption that a consumer can afford equals his total wealth consumer can afford equals his total wealth divided by his expected remaining life.divided by his expected remaining life.

Consumption depends not only on total wealth Consumption depends not only on total wealth but also on current income.but also on current income.

C C to ta l w ea l Y Tt L T t ( , )th t

Y TL T t human wealth, or the expected present human wealth, or the expected present value of after-tax labor incomevalue of after-tax labor income

Tt real taxes in year real taxes in year tt..

Y L t real labor income in year real labor income in year tt..

WealthWealth Consumer and saving habitsConsumer and saving habits Size of the populationSize of the population Income distributionIncome distribution Credit availabilityCredit availability Expectations of change in pricesExpectations of change in prices Expectations of future incomeExpectations of future income Interest ratesInterest rates

Shifts in the consumption functionShifts in the consumption function

Educational attainment of the head of the family and its Educational attainment of the head of the family and its membersmembers

Family sizeFamily size

Household Savings:Household Savings:

Income (permanent and transitory)Income (permanent and transitory) Interest ratesInterest rates Exchange rates (real effective exchange rates)Exchange rates (real effective exchange rates)

• Depreciation of the RUPEEDepreciation of the RUPEE• Appreciation of the RUPEEAppreciation of the RUPEE

Determinants of family income:Determinants of family income:

Engel’s Law (Ernst Engel)Engel’s Law (Ernst Engel) There is a relationship between the amount of income There is a relationship between the amount of income

and proportionate changes in consumption and proportionate changes in consumption expenditures as income level shifts.expenditures as income level shifts.

As the income of the family increases:As the income of the family increases:• A smaller percentage is spent for foodA smaller percentage is spent for food• Approximately the same for clothingApproximately the same for clothing• Constantly increasing percentage spent for education, health, Constantly increasing percentage spent for education, health,

recreation, amusement, travelrecreation, amusement, travel• Approximately the same percentage for rent, fuel and light.Approximately the same percentage for rent, fuel and light.

Putting Things Together: Current Income, Putting Things Together: Current Income, Expectations, and ConsumptionExpectations, and Consumption

Expectations affect consumption in two ways:Expectations affect consumption in two ways:

Directly through human wealth, or expectations of Directly through human wealth, or expectations of future labor income, real interest rates, and taxes.future labor income, real interest rates, and taxes.

Indirectly through nonhuman wealth—stocks, Indirectly through nonhuman wealth—stocks, bonds, and housing. Expectations of the value of bonds, and housing. Expectations of the value of nonhuman wealth is computed by financial nonhuman wealth is computed by financial markets.markets.

Putting Things Together: Current Income, Putting Things Together: Current Income, Expectations, and ConsumptionExpectations, and Consumption

Consumption is likely to respond less than one Consumption is likely to respond less than one for one to fluctuations in current income.for one to fluctuations in current income. Consumption may decrease one for one with a Consumption may decrease one for one with a

decrease in income only if the decrease in income is decrease in income only if the decrease in income is considered to be permanent.considered to be permanent.

Temporary changes in current income, such as those Temporary changes in current income, such as those caused by recessions and expansions, are unlikely to caused by recessions and expansions, are unlikely to increase consumption by as much as income.increase consumption by as much as income.

Consumption may move even if current income Consumption may move even if current income does not due to changes in consumer does not due to changes in consumer confidence.confidence.

InvestmentInvestment

Gross InvestmentGross Investment= Net Investment + Depreciation= Net Investment + Depreciation

Investment (flow variable)Investment (flow variable) Durable equipment, new buildings, increase in Durable equipment, new buildings, increase in

inventoriesinventories

Capital (stock variable)Capital (stock variable) Equal to the amount of accumulated investment as Equal to the amount of accumulated investment as

of a given point in time.of a given point in time.

InvestmentInvestment

Investment decisions depend on current sales, Investment decisions depend on current sales, the current real interest rate, and on the current real interest rate, and on expectations of the future.expectations of the future.

The decision to buy a machine depends on the The decision to buy a machine depends on the present value of the profits the firm can expect present value of the profits the firm can expect from having this machine versus the cost of from having this machine versus the cost of buying it.buying it.

Determinants of Investment:Determinants of Investment: Business Investment in durable equipmentBusiness Investment in durable equipment

• Rate of profitRate of profit• Interest rateInterest rate• Changes in expectationsChanges in expectations• Rate of innovationRate of innovation• Rate of change in outputRate of change in output

Inventory InvestmentInventory Investment• Rate of increase in salesRate of increase in sales

Residential constructionResidential construction• Change in income levelsChange in income levels• Cost of constructionCost of construction• Availability and cost of housing creditAvailability and cost of housing credit

Investment and Expectations of ProfitInvestment and Expectations of Profit

DepreciationDepreciation:: The rate of depreciation, measures how much The rate of depreciation, measures how much

usefulness the machine loses from one year usefulness the machine loses from one year to the next.to the next.

Reasonable values are between 4 and 15% Reasonable values are between 4 and 15% for machines, and between 2 and 4% for for machines, and between 2 and 4% for buildings and factories.buildings and factories.

Investment and the Stock MarketInvestment and the Stock Market

James Tobin argued that there should be a James Tobin argued that there should be a tight relation between the stock market and tight relation between the stock market and investment.investment.

The stock price tells firms how much the stock The stock price tells firms how much the stock market values each unit of capital already in market values each unit of capital already in place; thus, the willingness to pay for one place; thus, the willingness to pay for one more unit. If the stock market value exceeds more unit. If the stock market value exceeds the purchase price, the firm should buy the the purchase price, the firm should buy the machine.machine.

Profitability Versus Cash FlowProfitability Versus Cash Flow

ProfitabilityProfitability refers to the expected present refers to the expected present discounted value of profits.discounted value of profits.

Cash flowCash flow refers to current profit, or the net refers to current profit, or the net flow of cash the firm is receiving.flow of cash the firm is receiving.

Both profitability and cash flow are important Both profitability and cash flow are important for investment decisions, and are likely to for investment decisions, and are likely to move together.move together.

The Volatility ofThe Volatility ofConsumption and InvestmentConsumption and Investment

Investment is more volatile than consumption. Investment is more volatile than consumption.

Consumption and investment usually move Consumption and investment usually move

together. Both components contribute roughly together. Both components contribute roughly equally to fluctuations in output over time.equally to fluctuations in output over time.