Consumption 16-1 • 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.
The Very Foresighted Consumer • A very foresighted consumer who decide how much to consume based on the value of his total wealth, which comprises: • The value of his nonhuman wealth, or the sum of financial wealth and housing wealth. • The value of his human wealth, or the present value of expected after-tax labor income.
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. real labor income in year t. real taxes in year t. human wealth, or the expected present value of after-tax labor income
Toward a More Realistic Description • Evidence on the relative importance of wealth and current income in consumption decisions shows that both affect consumption. • This evidence is gathered through natural experiments—experiments that economists cannot control, but occur naturally.
Putting Things Together: Current Income, Expectations, and Consumption • 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.
Putting Things Together: Current Income, Expectations, and Consumption • Consumption is likely to respond less than one for one to fluctuations in current income. • Consumption may decrease one for one with a decrease in income only if the decrease in income is considered to be permanent. • Temporary changes in current income, such as those caused by recessions and expansions, are unlikely to increase consumption by as much as income. • Consumption may move even if current income does not due to changes in consumer confidence.
Investment 16-2 • 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.
Investment and Expectations of Profit Depreciation: • The rate of depreciation, , measures how much usefulness the machine loses 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.
Investment and Expectations of Profit The Present Value of Expected Profits, V(et): • The present value, in year t, of expected profit in year t+1 equals: • In year t+2, • In year t,
Investment and Expectations of Profit Computing the Present Value of Expected Profits
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: In words, investment depends positively on the expected present value of future profits (per unit of capital).
Investment and the Stock Market • James Tobin argued that there should be a tight relation between the stock market and investment. • The stock price tells firms how much the stock market values each unit of capital already in place; thus, the willingness to pay for one more unit. If the stock market value exceeds the purchase price, the firm should buy the machine.
Investment and the Stock Market • The stock market value of U.S. corporations (share price times number of shares) divided by the value of the capital stock of U.S. corporations is called Tobin’s q. • This ratio gives the value of a unit of capital relative to its current purchase price. The higher the value of capital relative to its current purchase price, the higher should be investment.
Investment and Expectations of Profit Tobin’s q Versus the Ratio of Investment to Capital—Annual Rates of Change, 1960-1999 There is a tight relation between investment and the value of the stock market.
A Convenient Special Case • Assume that: • Future profits and future interest rates remain the same as today, and • People have static expectations (expect the future to be like the present). • Under these assumptions, the equation becomes:
A Convenient Special Case • Investment is a function of the ratio of the profit per unit of capital to the sum of the real interest rate and the depreciation rate. • The term is called the user cost or the rental cost of capital. Given and then,
Current Versus Expected Profit • Investment depends on expected future profit, but also moves strongly with fluctuations in current profit. • 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. It does not need to convince potential lenders.
Investment and Expectations of Profit Changes in Investment and Changes in Profit in the United States, 1960-2000 Investment and profit move very much together.
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.
Profits and Sales Changes in Profit and Changes in the Ratio of Output to Capital in the United States, 1960-2000 Profit and the ratio of output to capital move largely together.
The Volatility ofConsumption and Investment 16-3 • Investment is more volatile than consumption. Consumers do not increase consumption more than one for one with increases in income. Investment, on the other hand, may exceed an increase in current sales. • Consumption and investment usually move together. Both components contribute roughly equally to fluctuations in output over time.
The Volatility ofConsumption and Investment Rates of Change of Consumption and Investment, 1960-2000 Relative movements in investment are much larger than relative movements in consumption.
Key Terms • permanent income theory of consumption, • life cycle theory of consumption, • financial wealth, • housing wealth, • human wealth, • nonhuman wealth, • total wealth, • natural experiment, • Tobin’s q, • static expectations, • user cost of capital, or rental cost of capital, • profitability, • cash flow,