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Lecture 11
Household and Firm Behavior in the
Macroeconomy: A Further Look
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
Expectations and Animal Spirits
Profit Maximization
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.
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Households: Consumption and Labor Supply Decisions
The Life-Cycle Theory of Consumption
 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.
permanent income The average level of a
person’s expected future income stream.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Households make consumption and labor
supply decisions simultaneously. 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
According to the substitution effect of a wage
rate increase, a higher wage leads to a larger
quantity of labor supplied—a larger workforce.
According to the income 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.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
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.
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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Wealth and Nonlabor Income
nonlabor, or nonwage, income Any income
received from sources other than working—
inheritances, interest, dividends, transfer
payments, and so on.
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.
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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Households: Consumption and Labor Supply Decisions
Interest Rate Effects on Consumption
A rise in the interest rate leads me to consume
less today and save more. This effect is called the
substitution effect of an interest rate change.
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.
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Households: Consumption and Labor Supply Decisions
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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Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
Households consume less if they are constrained
from working.
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
In Keynesian theory, current income determines
current consumption. It is incorrect to think
consumption depends only on income, at least
when there is full employment. However, if there
is unemployment, Keynes is closer to being
correct because income is not determined by
households. When there is unemployment, the
level of income (at least workers’ income)
depends exclusively on the employment decisions
made by firms.
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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

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
Consumption
 FIGURE 16.2 Consumption Expenditures, 1970 I–2007 IV
Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable
goods.
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Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970
Housing Investment
 FIGURE 16.3 Housing Investment of the Household Sector, 1970 I–2007 IV
Housing investment fell during the four 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
The Household Sector Since 1970
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–2007 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).
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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.
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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Firms: Investment and Employment Decisions
Profit Maximization
inputs The goods and services that firms
purchase and turn into output.
plant-and-equipment investment Purchases by
firms of additional machines, factories, or buildings
within a given period.
labor-intensive technology A production
technique that uses a large amount of labor relative
to capital.
capital-intensive technology A production
technique that uses a large amount of capital
relative to labor.
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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.
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
Stock of inventories (end of period) =
Stock of inventories (beginning of period)
+ Production - Sales
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Firms: Investment and Employment Decisions
Inventory Investment
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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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)

Amount of excess labor and excess capital on
hand
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Firms: Investment and Employment Decisions
A Summary of Firm Behavior
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
Plant-and-Equipment Investment
 FIGURE 16.5 Plant-and-Equipment Investment of the Firm Sector, 1970 I–2007 IV
Overall, plant-and-equipment investment declined in the four recessionary periods since 1970.
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Firms: Investment and Employment Decisions
The Firm Sector Since 1970
Employment
 FIGURE 16.6 Employment in the Firm Sector, 1970 I–2007 IV
Growth in employment was generally negative in the four recessions the U.S. economy has experienced
since 1970.
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Firms: Investment and Employment Decisions
The Firm Sector Since 1970
Inventory Investment
 FIGURE 16.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2007 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.
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Productivity and the Business Cycle
productivity, or labor productivity Output per
worker hour; the amount of output produced by an
average worker in 1 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 outputto-labor ratio) tends to rise during
expansionary periods and decline
during contractionary periods.
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Productivity and the Business Cycle
Productivity in the Long Run
Productivity figures can be misleading when used
to diagnose the health of the economy over the
short run, because business cycles can distort the
meaning of productivity measurements. Output
per worker falls in recessions because firms hold
excess labor during slumps. Output per worker
rises in expansions because firms put the excess
labor back to work. Neither of these conditions
has anything to do with the economy’s long-run
potential to produce output.
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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.
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The Short-Run Relationship Between Output and Unemployment
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.
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The Size of the Multiplier
The value of the multiplier in reality is smaller than
the simple multiplier. We can now summarize why.
1. There are automatic stabilizers.
2. The interest rate and the crowding-out effect.
3. The effect of expansionary policy on the price
level.
4. The fact that firms hold excess capital and
excess labor.
5. There are inventories.
6. There are people’s expectations.
The Size of the Multiplier in Practice
In practice, the multiplier probably has a value of
around 1.4. Its size also depends on how long ago
the spending increase began.
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REVIEW TERMS AND CONCEPTS
accelerator effect
inputs
adjustment costs
inventory investment
animal spirits of
labor-intensive technology
entrepreneurs
life-cycle theory of consumption
capital-intensive technology
nominal wage rate
constrained supply of labor
nonlabor, or nonwage, income
desired, or optimal, level of
Okun’s Law
inventories
permanent income
discouraged-worker effect
plant-and-equipment investment
excess capital
productivity, or labor productivity
excess labor
real wage rate
unconstrained supply of labor
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