Transcript Chapter 16. Expectations, Consumption, and Investment

Expectations,
Expectations,
Consumption,
Consumption,
and
and Investment
Investment
CHAPTER 16
Prepared by:
Fernando Quijano and Yvonn Quijano
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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
Chapter 16: Expectations, Consumption, and Investment
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 (Total wealth t )
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Chapter 16: Expectations, Consumption, and Investment
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 income—for 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
Chapter 16: Expectations, Consumption, and Investment
An Example
Building on what you saw in Chapter 14, let’s compute
the present value of your labor income as the value of
real expected after-tax labor income, discounted using
real interest rates.
V (YLte  Tt e )  ($40,000)(0.75)(72.2)  $2,166,000
Your wealth today, the expected value of your lifetime
after-tax labor income, is around $2 million.
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16-1 Consumption
Chapter 16: Expectations, Consumption, and Investment
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 (Total wealth t , YLT  Tt )
YLt 
real labor income in year t.
Tt 
real taxes in year t.
wealth, or the expected present
YLT  Tt  human
value of after-tax labor income
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16-1 Consumption
Toward a More Realistic Description
Chapter 16: Expectations, Consumption, and Investment
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
Chapter 16: Expectations, Consumption, and Investment
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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Chapter 16: Expectations, Consumption, and Investment
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
Chapter 16: Expectations, Consumption, and Investment
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
Chapter 16: Expectations, Consumption, and 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
Chapter 16: Expectations, Consumption, and Investment
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
Chapter 16: Expectations, Consumption, and Investment
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
e
t 1
e
t 1
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16-2 Investment
The Present Value of Expected Profits
Chapter 16: Expectations, Consumption, and Investment
Figure 16 - 1
Computing the Present
Value of Expected
Profits
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16-2 Investment
Chapter 16: Expectations, Consumption, and 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
Chapter 16: Expectations, Consumption, and Investment
Suppose firms expect both future profits and future interest
rates to remain at the same level as today, so that
 te1   te 2  ... =  t
and
rt 1  rt  2  ... = rt
e
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
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Investment and the Stock Market
Chapter 16: Expectations, Consumption, and Investment
Tobin’s q denotes the variable corresponding to the value of a
unit of capital in place relative to its purchase price.
Figure 1
Tobin’s q versus the Ratio of Investment to Capital:
Annual Rates of Change, 1960 to 1999
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16-2 Investment
A Convenient Special Case
t
Putting V ( )  r   and I  I [V ( )] together give
us an equation for investment:
e
t
Chapter 16: Expectations, Consumption, and Investment
t
e
t
t
 t 

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 = ( rt
)
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16-2 Investment
Current versus Expected Profit
Chapter 16: Expectations, Consumption, and Investment
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
t
t
(
+
t
, +)
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
Chapter 16: Expectations, Consumption, and Investment
Figure 16 - 2
Changes in Investment
and Changes in Profit in
the United States since
1960
Investment and profit move
very much together.
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Chapter 16: Expectations, Consumption, and Investment
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
Chapter 16: Expectations, Consumption, and Investment
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.
t
 Yt 

 
 Kt 
(+)
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16-3 The Volatility of Consumption
and Investment
Chapter 16: Expectations, Consumption, and Investment
Let’s 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.
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16-3 The Volatility of Consumption
and Investment
Chapter 16: Expectations, Consumption, 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.
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16-3 The Volatility of Consumption
and Investment
Chapter 16: Expectations, Consumption, 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.
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16-3 The Volatility of Consumption
and Investment
Chapter 16: Expectations, Consumption, 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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Chapter 16: Expectations, Consumption, and Investment
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
 Tobin’s q
 static expectations
 user cost of capital, or
rental cost of capital
 profitability
 cash flow
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