Download inventory investment

1 of 28
© 2014 Pearson Education, Inc.
2 of 28
Household and Firm Behavior
in the Macroeconomy:
A Further Look*
16
CHAPTER OUTLINE
Households: Consumption and Labor
Supply Decisions
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!
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
© 2014 Pearson Education, Inc.
3 of 28
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.
permanent income The average level of a person’s expected future income
stream.
© 2014 Pearson Education, Inc.
4 of 28
 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.
© 2014 Pearson Education, Inc.
5 of 28
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.
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.
© 2014 Pearson Education, Inc.
6 of 28
Prices
nominal wage rate The wage rate in current dollars.
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.
© 2014 Pearson Education, Inc.
7 of 28
Wealth and Nonlabor Income
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.
© 2014 Pearson Education, Inc.
8 of 28
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.
© 2014 Pearson Education, Inc.
9 of 28
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.
Transfer payments are payments such as Social Security benefits, veterans’
benefits, and welfare benefits.
© 2014 Pearson Education, Inc.
10 of 28
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.
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.
© 2014 Pearson Education, Inc.
11 of 28
Keynesian Theory Revisited
Recall the Keynesian theory that current income determines current
consumption.
Both consumption and labor supply decisions depend on the real wage rate,
but if there is unemployment, it is income, not the wage rate, that affects
consumption.
Developed during a period of unemployment, Keynesian theory is considered
to pertain to such periods.
© 2014 Pearson Education, Inc.
12 of 28
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
Current and expected future nonlabor income
Interest rates
Current and expected future tax rates and transfer payments
© 2014 Pearson Education, Inc.
13 of 28
The Household Sector Since 1970
Consumption
 FIGURE 16.2 Consumption Expenditures, 1970 I–2012 IV
Over time, expenditures on services and nondurable goods
are “smoother” than expenditures on durable goods.
© 2014 Pearson Education, Inc.
14 of 28
Housing Investment
 FIGURE 16.3 Housing Investment of the Household Sector, 1970 I–2012 IV
Housing investment fell during the five recessionary periods since 1970.
Like expenditures for durable goods, expenditures for housing investment are postponable.
© 2014 Pearson Education, Inc.
15 of 28
EC ON OMIC S IN PRACTICE
Measuring Housing Price Changes
One way to measure housing price changes is to look at changes in the
average price of a house in a city over time.
An alternative is to try to standardize the house type, say looking at the change
in the average price of a four-bedroom house in an area over time.
Karl Case, working with Robert Shiller, a behavioral finance economist,
developed an index that neatly solves the problem that houses are all different.
The Case-Shiller index looks only at houses that have sold multiple times and
asks the question: How much does an identical house sell for now versus in
the past?
THINKING PRACTICALLY
1. Who, other than macroeconomists, might be interested in trading the Case-Schiller
index?
© 2014 Pearson Education, Inc.
16 of 28
Labor Supply
 FIGURE 16.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All
Others 16 and Over, 1970 I–2012 IV
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).
© 2014 Pearson Education, Inc.
17 of 28
Firms: Investment and Employment Decisions
Expectations and Animal Spirits
animal spirits of entrepreneurs A term coined by Keynes to describe
investors’ feelings.
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.
© 2014 Pearson Education, Inc.
18 of 28
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.
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.
© 2014 Pearson Education, Inc.
19 of 28
Inventory Investment
inventory investment The change in the stock of inventories.
The Role of Inventories
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).
© 2014 Pearson Education, Inc.
20 of 28
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)
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.
© 2014 Pearson Education, Inc.
21 of 28
The Firm Sector Since 1970
Plant-and-Equipment Investment
 FIGURE 16.5 Plant-and-Equipment Investment of
the Firm Sector, 1970 I–2012 IV
Overall, plant-and-equipment investment declined
in the five recessionary periods since 1970.
© 2014 Pearson Education, Inc.
22 of 28
Employment
 FIGURE 16.6 Employment in the Firm Sector, 1970 I–2012 IV
Growth in employment was generally negative in the five recessions the U.S. economy
has experienced since 1970.
© 2014 Pearson Education, Inc.
23 of 28
Inventory Investment
 FIGURE 16.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2012 IV
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.
© 2014 Pearson Education, Inc.
24 of 28
Productivity and the Business Cycle
productivity, or labor productivity Output per worker hour.
 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-to-labor ratio)
tends to rise during
expansionary
periods and decline
during
contractionary
periods.
© 2014 Pearson Education, Inc.
25 of 28
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
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.
© 2014 Pearson Education, Inc.
26 of 28
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.
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.
© 2014 Pearson Education, Inc.
27 of 28
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 labor, excess capital
real wage rate
inventory investment
unconstrained supply of labor
© 2014 Pearson Education, Inc.
28 of 28