Download Household and Firm Behavior

PRINCIPLES OF
MACROECONOMICS
PART IV Further Macroeconomics Issues
TENTH EDITION
CASE FAIR OSTER
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Prepared by: Fernando Quijano & Shelly
1 ofTefft
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PART IV Further Macroeconomics Issues
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Household and Firm Behavior
in the Macroeconomy:
A Further Look*
16
CHAPTER OUTLINE
Households: Consumption and Labor
Supply Decisions
PART IV Further Macroeconomics Issues
The Life-Cycle Theory of Consumption
The Labor Supply Decision
Interest Rate Effects on Consumption
Government Effects on Consumption and Labor
Supply: Taxes and Transfers
A Possible Employment Constraint on Households
A Summary of Household Behavior
The Household Sector Since 1970
Firms: Investment and Employment
Decisions
* This chapter is somewhat more advanced,
but it contains a lot of interesting information!
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Expectations and Animal Spirits
Excess Labor and Excess Capital Effects
Inventory Investment
A Summary of Firm Behavior
The Firm Sector Since 1970
Productivity and the Business Cycle
The Short-Run Relationship Between
Output and Unemployment
The Size of the Multiplier
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Households: Consumption and Labor Supply Decisions
The Life-Cycle Theory of Consumption
life-cycle theory of consumption A theory of household
consumption: Households make lifetime consumption
decisions based on their expectations of lifetime income.
PART IV Further Macroeconomics Issues
permanent income The average level of a person’s
expected future income stream.
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Households: Consumption and Labor Supply Decisions
The Life-Cycle Theory of Consumption
PART IV Further Macroeconomics Issues
 FIGURE 16.1
Life-Cycle Theory
of Consumption
In their early
working years,
people consume
more than they
earn.
This is also true
in the retirement
years.
In between,
people save
(consume less
than they earn)
to pay off debts
from borrowing
and to
accumulate
savings for
retirement.
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PART IV Further Macroeconomics Issues
In the life-cycle theory of consumption,
a.
The more income you have, the more consuming you are likely to
do.
b.
High-income households consume a smaller proportion of their
income than low-income households.
c.
People tend to consume less than they earn during their main
working years.
d.
All of the above.
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PART IV Further Macroeconomics Issues
In the life-cycle theory of consumption,
a.
The more income you have, the more consuming you are likely to
do.
b.
High-income households consume a smaller proportion of their
income than low-income households.
c.
People tend to consume less than they earn during their main
working years.
d.
All of the above.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Demographics and both legal and illegal immigration play a role in
determining the size of the labor force.
Behavior also plays a role. Consumption cannot be considered
separately from labor supply because it is precisely by selling your
labor that you earn income to pay for your consumption.
PART IV Further Macroeconomics Issues
The Wage Rate
A higher wage would lead to a larger quantity of labor
supplied—a larger workforce. This is called the substitution
effect of a wage rate increase.
If we assume that leisure is a normal good, people with
higher income will spend some of it on leisure by working
less. This is the income effect of a wage rate increase.
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PART IV Further Macroeconomics Issues
The data suggest that the substitution effect of a wage increase seems
to win over the income effect. This means that:
a.
Higher wage rates usually lead to a larger labor supply.
b.
Higher wage rates usually lead to a lower labor supply.
c.
Higher wages may or may not increase labor supply.
d.
There is no relationship between wages and labor supply.
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PART IV Further Macroeconomics Issues
The data suggest that the substitution effect of a wage increase seems
to win over the income effect. This means that:
a.
Higher wage rates usually lead to a larger labor supply.
b.
Higher wage rates usually lead to a lower labor supply.
c.
Higher wages may or may not increase labor supply.
d.
There is no relationship between wages and labor supply.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Prices
nominal wage rate The wage rate in current dollars.
PART IV Further Macroeconomics Issues
real wage rate The amount the nominal wage rate
can buy in terms of goods and services.
Households look at expected future real wage rates as well
as the current real wage rate in making their current
consumption and labor supply decisions.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Wealth and Nonlabor Income
PART IV Further Macroeconomics Issues
Holding everything else constant (including the stage in the
life cycle), the more wealth a household has, the more it will
consume both now and in the future.
nonlabor, or nonwage, income Any income received
from sources other than working—inheritances, interest,
dividends, transfer payments, and so on.
An unexpected increase in nonlabor income will have a
positive effect on a household’s consumption.
An unexpected increase in wealth or nonlabor income leads
to a decrease in labor supply.
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PART IV Further Macroeconomics Issues
All else the same, an unexpected increase in wealth or nonlabor income
causes:
a.
An increase in labor supply, an increase in present consumption,
and a decrease in future consumption.
b.
A decrease in labor supply, a decrease in present consumption,
and an increase in future consumption.
c.
A decrease in labor supply, and an increase in both present and
future consumption.
d.
No change in labor supply, but higher present and future
consumption.
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PART IV Further Macroeconomics Issues
All else the same, an unexpected increase in wealth or nonlabor income
causes:
a.
An increase in labor supply, an increase in present consumption,
and a decrease in future consumption.
b.
A decrease in labor supply, a decrease in present consumption,
and an increase in future consumption.
c.
A decrease in labor supply, and an increase in both present
and future consumption.
d.
No change in labor supply, but higher present and future
consumption.
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Households: Consumption and Labor Supply Decisions
Interest Rate Effects on Consumption
A rise in the interest rate leads you to consume less today and save
more. This effect is called the substitution effect.
There is also an income effect of an interest rate change on
consumption. If a household has positive wealth and is earning
interest on that wealth, a fall in the interest rate leads to a fall in
interest income.
PART IV Further Macroeconomics Issues
Government Effects on Consumption and Labor Supply: Taxes and Transfers
TABLE 16.1 The Effects of Government on Household Consumption and Labor Supply
Income Tax Rates
Transfer Payments
Increase
Decrease
Increase
Decrease
Effect on consumption
Negative
Positive
Positive
Negative
Effect on labor supply
Negative*
Positive*
Negative
Positive
*If the substitution effect dominates.
Note: The effects are larger if they are expected to be permanent instead of temporary.
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PART IV Further Macroeconomics Issues
If the substitution effect of a change in wages dominates, then an
increase in income tax rates:
a.
Increases after-tax wages and increases labor supply.
b.
Increases after-tax wages and lowers labor supply.
c.
Lowers after-tax wages and increases labor supply.
d.
Lowers after-tax wages and lowers labor supply.
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PART IV Further Macroeconomics Issues
If the substitution effect of a change in wages dominates, then an
increase in income tax rates:
a.
Increases after-tax wages and increases labor supply.
b.
Increases after-tax wages and lowers labor supply.
c.
Lowers after-tax wages and increases labor supply.
d. Lowers after-tax wages and lowers labor supply.
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Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
How does a household respond when it is constrained from working
as much as it would like?
It consumes less.
PART IV Further Macroeconomics Issues
unconstrained supply of labor The amount a
household would like to work within a given period at the
current wage rate if it could find the work.
constrained supply of labor The amount a household
actually works in a given period at the current wage rate.
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Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
Keynesian Theory Revisited
PART IV Further Macroeconomics Issues
Recall the Keynesian theory that current income determines
current consumption.
Although consumption and labor supply decisions depend on
the real wage rate, if there is unemployment, income
depends on the employment decisions made by firms and
not on household decisions.
Developed during a period of unemployment, Keynesian
theory is considered to pertain to those periods.
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Households: Consumption and Labor Supply Decisions
A Summary of Household Behavior
The following factors affect household consumption and labor supply
decisions:
Current and expected future real wage rates
Initial value of wealth
PART IV Further Macroeconomics Issues
Current and expected future nonlabor income
Interest rates
Current and expected future tax rates and transfer payments
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Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970
 FIGURE 16.2 Consumption Expenditures, 1970 I–2010 I
PART IV Further Macroeconomics Issues
Consumption
Over time, expenditures on services and nondurable
goods are “smoother” than expenditures on durable goods.
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PART IV Further Macroeconomics Issues
Which category of expenditures is “smoother” over time?
a.
Expenditures on services and nondurable goods.
b.
Expenditures on durable goods.
c.
Housing expenditures.
d.
All of the above categories of expenditures are very smooth over
time.
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PART IV Further Macroeconomics Issues
Which category of expenditures is “smoother” over time?
a.
Expenditures on services and nondurable goods.
b.
Expenditures on durable goods.
c.
Housing expenditures.
d.
All of the above categories of expenditures are very smooth over
time.
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EC ON OMIC S IN PRACTICE
Household Reactions to Winning the Lottery
The more nuanced theory of
consumption that we have
explored in this chapter makes
some predictions about what
households will do if they have a
sudden increase in wealth.
PART IV Further Macroeconomics Issues
Of course, such increases are
uncommon, but winning the
lottery is one such example.
A study by three economists,
Guido Imbens, Donald Rubin, and Bruce Sacerdote, of a large sample of
lottery winners found that winning reduced work hours by 11 percent and that
of the first half of lottery winnings received, 16 percent on average was saved.
Smith Prepares to Leave Office after Winning Lottery
The Baltimore Sun
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Households: Consumption and Labor Supply Decisions
 FIGURE 16.3 Housing Investment of the Household
Sector, 1970 I–2010 I
The Household Sector Since 1970
PART IV Further Macroeconomics Issues
Housing Investment
Housing investment fell during the five
recessionary periods since 1970.
Like expenditures for durable goods, expenditures
for housing investment are postponable.
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Households: Consumption and Labor Supply Decisions
 FIGURE 16.4 Labor Force Participation Rates for Men 25 to 54, Women 25
to 54, and All Others 16 and Over, 1970 I–2010 I
The Household Sector
Since 1970
PART IV Further Macroeconomics Issues
Labor Supply
Since 1970, the labor force participation rate for prime-age men has been
decreasing slightly.
The rate for prime-age women has been increasing dramatically.
The rate for all others 16 and over has been declining since 1979 and shows
a tendency to fall during recessions (the discouraged-worker effect).
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Firms: Investment and Employment Decisions
Expectations and Animal Spirits
animal spirits of entrepreneurs A term coined
by Keynes to describe investors’ feelings.
PART IV Further Macroeconomics Issues
The Accelerator Effect
accelerator effect The tendency for investment
to increase when aggregate output increases and
to decrease when aggregate output decreases,
accelerating the growth or decline of output.
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PART IV Further Macroeconomics Issues
When Keynes referred to the animal spirits of entrepreneurs, he meant
that:
a.
Investment decisions are always made with imperfect knowledge.
b.
Investment activity depends on psychology.
c.
Investment is based on expectations involving great uncertainty.
d.
All of the above.
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PART IV Further Macroeconomics Issues
When Keynes referred to the animal spirits of entrepreneurs, he meant
that:
a.
Investment decisions are always made with imperfect knowledge.
b.
Investment activity depends on psychology.
c.
Investment is based on expectations involving great uncertainty.
d. All of the above.
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Firms: Investment and Employment Decisions
Excess Labor and Excess Capital Effects
excess labor, excess capital Labor and capital that are
not needed to produce the firm’s current level of output.
PART IV Further Macroeconomics Issues
adjustment costs The costs that a firm incurs when it
changes its production level—for example, the
administration costs of laying off employees or the training
costs of hiring new workers.
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Firms: Investment and Employment Decisions
Inventory Investment
inventory investment The change in the stock of inventories.
The Role of Inventories
PART IV Further Macroeconomics Issues
Stock of inventories (end of period) =
Stock of inventories (beginning of period)
+ Production − Sales
The Optimal Inventory Policy
desired, or optimal, level of inventories The level of
inventory at which the extra cost (in lost sales) from lowering
inventories by a small amount is just equal to the extra gain (in
interest revenue and decreased storage costs).
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PART IV Further Macroeconomics Issues
If the costs of adjusting production levels are greater than the costs of
maintaining inventories,
a.
A firm will immediately adjust production to match any increases or
decreases in sales.
b.
Output produced will tend to be less than output sold.
c.
A firm may lower production by less than a decrease in sales,
allowing inventories to rise.
d.
Fluctuations in production will be greater than the corresponding
fluctuations in sales.
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PART IV Further Macroeconomics Issues
If the costs of adjusting production levels are greater than the costs of
maintaining inventories,
a.
A firm will immediately adjust production to match any increases or
decreases in sales.
b.
Output produced will tend to be less than output sold.
c.
A firm may lower production by less than a decrease in sales,
allowing inventories to rise.
d.
Fluctuations in production will be greater than the corresponding
fluctuations in sales.
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Firms: Investment and Employment Decisions
A Summary of Firm Behavior
The following factors affect firms’ investment and employment decisions:
Firms’ expectations of future output
Wage rate and cost of capital (the interest rate is an important
component of the cost of capital)
PART IV Further Macroeconomics Issues
Amount of excess labor and excess capital on hand
The most important points to remember about the relationship among
production, sales, and inventory investment are
Inventory investment—that is, the change in the stock of
inventories—equals production minus sales.
An unexpected increase in the stock of inventories has a negative
effect on future production.
Current production depends on expected future sales.
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Firms: Investment and Employment Decisions
The Firm Sector Since 1970
 FIGURE 16.5 Plant-and-Equipment Investment of the
Firm Sector, 1970 I–2010 I
Overall, plant-and-equipment investment declined
in the five recessionary periods since 1970.
PART IV Further Macroeconomics Issues
Plant-and-Equipment Investment
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Firms: Investment and Employment Decisions
 FIGURE 16.6 Employment in the Firm Sector, 1970 I–2010 I
The Firm Sector Since 1970
Growth in employment was generally negative in the
five recessions the U.S. economy has experienced
since 1970.
PART IV Further Macroeconomics Issues
Employment
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Firms: Investment and Employment Decisions
The Firm Sector Since 1970
The inventory/sales ratio is the ratio of the firm
sector’s stock of inventories to the level of sales.
Inventory investment is very volatile.
PART IV Further Macroeconomics Issues
Inventory Investment
 FIGURE 16.7 Inventory Investment of the Firm
Sector and the Inventory/Sales Ratio, 1970 I–2010 I
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Productivity and the Business Cycle
productivity, or labor productivity Output per worker hour.
PART IV Further Macroeconomics Issues
 FIGURE 16.8
Employment and
Output over the
Business Cycle
In general,
employment
does not
fluctuate as
much as
output over the
business
cycle.
As a result,
measured
productivity
(the output-tolabor ratio)
tends to rise
during
expansionary
periods and
decline during
contractionary
periods.
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The Short-Run Relationship Between Output and Unemployment
Okun’s Law The theory, put forth by Arthur Okun, that in the
short run the unemployment rate decreases about 1 percentage
point for every 3 percent increase in real GDP. Later research
and data have shown that the relationship between output and
unemployment is not as stable as Okun’s “Law” predicts.
Let E denote the number of people employed, let L denote the number of
people in the labor force, and let u denote the unemployment rate.
In these terms, the unemployment rate is
PART IV Further Macroeconomics Issues
u = 1 − E/L
The unemployment rate is 1 minus the employment rate, E/L.
discouraged-worker effect The decline in the measured
unemployment rate that results when people who want to work
but cannot find work grow discouraged and stop looking,
dropping out of the ranks of the unemployed and the labor force.
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The Size of the Multiplier
We can finally bring together the material in this chapter and in previous
chapters to consider the size of the multiplier. Earlier we mentioned that much of
the analysis we would do after deriving the simple multiplier would have the
effect of decreasing the size of the multiplier.
We can now summarize why:
1. There are automatic stabilizers.
2. There is the interest rate.
3. There is the response of the price level.
PART IV Further Macroeconomics Issues
4. There are excess capital and excess labor.
5. There are inventories.
6. There are people’s expectations about the future.
The Size of the Multiplier in Practice
In practice, the multiplier probably has a value of around 2.0.
Its size also depends on how long ago the spending increase began.
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PART IV Further Macroeconomics Issues
REVIEW TERMS AND CONCEPTS
accelerator effect
life-cycle theory of consumption
adjustment costs
nominal wage rate
animal spirits of entrepreneurs
nonlabor, or nonwage, income
constrained supply of labor
Okun’s Law
desired, or optimal, level of inventories
permanent income
discouraged-worker effect
productivity, or labor productivity
excess capital
real wage rate
excess labor
unconstrained supply of labor
inventory investment
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