Household and Firm Behavior in the Macroeconomy: A Further Look

1. Household and Firm Behavior in the Macroeconomy:A Further Look

2. Households: Consumption andLabor Supply Decisions • Keynes suggested that consumption is a positive function of income, and that high-income households consume a smaller portion of their income than low-income households.

3. The Keynesian Theory of Consumption: A Review • The average propensity to consume (APC) is the proportion of income households spend on consumption. Determined by dividing consumption (C) by income (Y).

4. The Life-Cycle Theory of Consumption • The life-cycle theory of consumption is an extension of Keynes's theory. It states that households make lifetime consumption decisions based on their expectations of lifetime income.

5. The Life-Cycle Theory of Consumption • People tend to consume less than they earn during their main working years, and dissave, or use up savings, during their early and later years.

6. The Life-Cycle Theory of Consumption • Consumption decisions are likely to be based on permanent income rather than on current income. • Permanent income is the average level of one’s expected future income stream.

7. The Life-Cycle Theory of Consumption • Policy changes, like tax-rate changes, are likely to have more of an effect on household behavior if they are expected to be permanent rather than temporary.

8. 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.

9. The Labor Supply Decision • Factors that determine the quantity of labor supplied include: • The wage rate • Prices • Wealth and nonlabor income

10. The Labor Supply Decision • An increase in the wage rate causes the opportunity cost of leisure to rise, leading to a larger labor supply—a larger labor force. This is called the substitution effect of a wage rate increase.

11. The Labor Supply Decision • A higher wage means that people will spend some of it on leisure by working less. This is the income effect of a wage rate increase. • Data suggests that the substitution effect prevails over the income effect, so higher wages lead to an increase in labor supply.

12. The Labor Supply Decision • Prices also play a major role in the consumption/labor supply decision. • The nominal wage rate is the wage rate in current dollars. • The real wage rate is the amount that the nominal wage rate can buy in terms of goods and services.

13. The Labor Supply Decision • Workers do not care about their nominal wage—they care about the purchasing power of this wage—the real wage rate.

14. The Labor Supply Decision • Wealth fluctuates over the life cycle. • 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.

15. The Labor Supply Decision • An increase in wealth can be looked on as an increase in nonlabor income. • Nonlabor, or nonwage, income is income received from sources other than working – inheritances, interest, dividends, and transfer payments, and so on.

16. The Labor Supply Decision • 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.

17. Interest Rate Effects on Consumption • A rise in the interest rate increases the reward to saving and lowers consumption. This is the substitution effect of an interest rate change. • There is also an income effect of an interest rate change. A fall in the interest rate leads to a fall in nonlabor income and consumption.

18. Interest Rate Effects on Consumption • For households with positive wealth, the income effect of an interest rate change works in the opposite direction from the substitution effect. • When a household is a debtor, a fall in the interest rate means a fall in interest payments, so the income and substitution effects work in the same direction.

19. Government Effects on Consumptionand Labor Supply: Taxes and Transfers • The government influences household behavior mainly through income tax rates and transfer payments. • Transfer payments are payments such as Social Security benefits, veterans benefits, and welfare benefits.

20. Government Effects on Consumptionand Labor Supply: Taxes and Transfers

21. A Possible EmploymentConstraint on Households • The budget constraint, which separates those bundles of goods that are available to a household from those that are not, is determined by income, wealth, and prices. • Households consume less if they are constrained from working.

22. A Possible EmploymentConstraint on Households • The amount that a household would like to work within a given period at the current wage rate if it could find the work is called the unconstrained supply of labor.

23. A Possible EmploymentConstraint on Households • The amount that a household actually works in a given period at the current wage rate is the constrained supply of labor. • A household’s constrained supply of labor is not a variable over which it has any control.

24. Keynesian Theory Revisited • It is incorrect to think consumption depends only on income, at least when there is full employment. • But if there is unemployment, the level of income depends exclusively on the employment decisions made by firms.

25. Keynesian Theory Revisited • To the extent that Keynes emphasized the relationship between consumption and income, Keynesian theory is considered to pertain to periods of unemployment.

26. A Summary of Household Behavior • Factors that affect household consumption and labor supply decisions include: • 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

27. Consumption Expenditures,1970 I – 2003 II

28. Housing Investment of theHousehold Sector, 1970 I – 2003 II

29. Labor-Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I – 2003 II

30. Firms: Investment andEmployment Decisions • Inputs are the goods and services that firms purchase and turn into output.

31. Investment Decisions • There are two ways that a firm can add to its capital stock: • Plant-and-equipment investment refers to purchases by firms of additional machines, factories, or buildings within a given period. • Inventory investment occurs when a firm produces more output than it sells within a given period.

32. Employment Decisions • If the demand for labor increases at a time of less-than-full employment, the unemployment rate will fall. • If the demand for labor increases when there is full employment, wage rates will rise.

33. Employment Decisions • The demand for new capital, or planned investment spending, which is partly determined by the interest rate, is as important as the demand for labor.

34. Decision Makingand Profit Maximization • A profit-maximizing firm chooses the technology that is most efficient—the one that minimizes the cost of production. • The most efficient technology depends on the relative prices of capital and labor.

35. Decision Makingand Profit Maximization • A labor-intensive technology is a production technique that uses a large amount of labor relative to capital. • A capital-intensive technology is a production technique that uses a large amount of capital relative to labor.

36. Decision Makingand Profit Maximization • Firms’ decisions about labor demand and investment are likely to depend on the relative costs of labor and capital. • The relative impact of an expansion of output on employment and on investment demand depends on the wage rate and the cost of capital.

37. Expectations and Animal Spirits • Investment decisions require looking into the future and forming expectations about it. • Expectations are always formed with imperfect information.

38. Expectations and Animal Spirits • Keynes concludes that much investment activity depends on psychology and on what he calls the animal spirits of entrepreneurs (a phrase that describes investors’ feelings), which help to make investment a volatile component of GDP.

39. The Accelerator Effect • The accelerator effect is the tendency for investment to increase when aggregate output increases and decrease when aggregate output decreases, accelerating the growth or decline of output.

40. The Accelerator Effect • If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low, further accelerating the growth of output.

41. Excess Labor andExcess Capital Effects • Excess labor and/or excess capital are labor and capital that are not needed to produce the firm’s current level of output. • Decreasing its workforce and capital stock quickly can be costly for a firm.

42. Excess Labor andExcess Capital Effects • Adjustment costs are 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.

43. Inventory Investment • Inventories are counted as part of a firm’s capital stock.

44. Inventory Investment • The desired, or optimal, level of inventories is 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).

45. Inventory Investment • There is a trade-off between holding inventories and changing production levels. • A firm’s production should fluctuate less than its sales, with changes in inventories absorbing the difference each period.

46. Inventory Investment • An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production.

47. Inventory Investment • A firm’s planned production path depends on the level of its expected future sales. • Future sales expectations are likely to have an important effect on current production.

48. A Summary of Firm Behavior • The following factors affect firms’ investment and employment decisions: • The wage rate and the cost of capital. • Firms’ expectations of future output. • The amount of excess labor and excess capital on hand.

49. A Summary of Firm Behavior • The most important points to remember about the relationship between production, sales, and inventory investment are: • Inventory investment (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.

50. Plant and Equipment Investmentof the Firm Sector, 1970 I – 2003 II