Consumption and Investement Flashcards
Consumption of forward-looking consumer depends…
on total wealth
Total wealth contain?
-Financial wealth
-Housing wealth
-Human wealth
Financial wealth
The value of checking and saving accounts, stocks and bonds net of liabilities
Housing wealth
The value of the house owned and other real estate net of the mortgages
Human wealth
Present value of the after-tax labor income over the working life
How expectation of higher output in the future affect consumption today ?
- Expected future output increases
–> Expected futur labor income increase
–> Human wealth increases
–> Consumption increases
–> Expected future dividends increase
–> Nonhuman wealth increases
–> Consumption increases
=Consumption may move even if current income does not change –> depend more on current sales, current real interest and expectation of the future.
Investement depends positively on ?
on the expected present value of future profits (per unit of capital)
–> The higher the expected profits, the higher the expected present value and the higher the level of investment.
= consumption can move even if current income doesn’t change
What determine profit per unit of capital?
- The level of sales
- The existing capital stock
permanent income theory of consumption
The modern theory of consumption
Household budget constraint
C t + ( A t + 1 − A t ) = W t/ Pt x L st + r t A t − T t
Theory of Investement
compare the present value of expected profits with the present value of the cost (example: price of a new maschine)
The expected present value is equal to:
the discounted value of expected profit next year, plus the discounted value of expected profit two years from now (taking into ac- count the depreciation of the machine), and so on.
Present value of the expected, discounted real prots generated by the investment: (formula)
V (Πe ) = Πet+1/(1 + rt) + (1 − δ)Πet+2/ (1+rt)(1+re ) + …
The depreciation rate δ per year quantie
how long the machine will last
Example:
Machines: δ is 4%-15%
Buildings and factories: δ is 2%-4%
If the present value is less than 1 what should do the firm? (investment)
the firm should not buy the machine.
–> If it did, it would be paying more for the machine than it expects to get back in profits later
If the present value exceeds 1. what should do the firm ? (investment)
the company is encouraged to buy the new machine
Investment depends positively on ?
both on the expected present value of future profits and on the current level of profit.
–> The higher the expected profits, the higher the expected present value and the higher the level of investment
–> The higher expected real interest rates, the lower the expected present value, and thus the lower the level of investment
Special case for constant interest rates and prots, equal to their current value:
V(Πet)= Πt / rt + δ
User cost (calculation)
rt + δ
Investment (calculation)
It =I(V(Πet))
In the special case (user cost and investement, calculation)
It = I( Πt/ rt +δ )
Investement definition
is a function of the ratio between the prot per unit of capital and the user cost
What determine profit per unit of capital?
- The level of sales
- The existing capital stock
Profit per unit of capital is what as a function?
is an increasing function of the ratio of sales to the capital stock. For a given capital stock, the higher the sales, the higher the profit per unit of capital. For given sales, the higher the capital stock, the lower the profit per unit of capital.
user cost/ rental cost of capital (definition)
the total cost incurred by a firm for using a capital asset over a specific period (Depreciation, Maintenance Costs, Opportunity Cost, Financing Costs)
Tobin’s Q purpose
constructed a variable corresponding to the value of a unit of capital in place relative to its purchase price and looked at how closely it moved with investment
Relationship between
- Stock market: valuation of an already invested unit of capital
-Purchase price for a new unit of capital
Tobin q : what is representing the symbol q ?
He used the symbol q to denote the variable (from the definition) , and the variable has become known as Tobin’s q.
Empirical computation for equity-financed firms:
share price times the number of shares, divided by the value of the capital stock (at current purchase price)
Q > 1 (tobin q)
This suggests that the market values the firm more than the cost of replacing its assets, possibly indicating overvaluation.
Q < 1
This indicates that the firm’s assets are valued by the market at less than their replacement cost, which may suggest undervaluation or inefficiency.
Q = 1
implies that the market value equals the replacement cost, suggesting the firm is neither over- nor undervalued.
In theory in Tobin’s Q : relationship between investement and stock market
a high correlation is expected between investment and stock market values. T
–> This is because stock prices reflect the present value of expected future profits. A higher stock price signals greater expected returns, which should incentivize firms to invest more in capital, expansion, and other projects.
Empirically in Tobin’s Q : relationship between investement and stock market
current profits (cash flows) often have a greater impact on investment decisions than would be suggested by the theoretical relationship between stock prices and investment (i.e., present value models). This suggests that firms may prioritize their current profitability and internal funds over the broader stock market signals.
Volatility of consumption and Investment: effect with the GDP
- Investement is more volatile than GDP
–> investment decisions : influenced by factors like interest rates, business expectations, and economic uncertainty (react to change in the economy)
- Consumption less volatile than GDP:
–> Consumption is primarily driven by households, and households generally prefer to smooth their consumption over time.
–> Even if Income falls they will use their saving or borrowing to maintain their consumption levels
Cosumption and investement move together : during expansion
higher income, employment, and confidence typically lead to both increased consumption and investment. Households spend more, and businesses invest more in capacity, responding to higher demand.
Cosumption and investement move together : During recessions
lower income, uncertainty, and reduced demand lead to lower consumption and investment. Businesses delay or reduce investments, and households cut back on spending.
Extension of the IS curve
Y =A(Y,T,r,x,Y′e + ,T′e,r′e,x′e)+G
Y =A(Y,T,r,x,Y′e + ,T′e,r′e,x′e)+G, what is A ?
A = aggregate private spending/ private spending
Increase of A
Increases in either current or expected future income increases private spending
Decrease of A
- Increases in either current or expected future Taxes
- Increases in either current or expected future real policy
- Decrease private spending
New IS curve (with consequences of A)
The new IS curve is steeper (see representation page 18)
A lower interest rate has a smaller eect on output
Reasons:
- A fall of the current interest rate has no strong effect on expenditures unless it is accompanied by a fall of expected future interest rates
-If income changes only transitorily, the eect on consumption and investment is small
IS curve: a change in any variable (other than Y or G) has which impact ?
- shifts the IS curve
–> Change in current Taxes or current gouvernemet expenditure shifts the curve IS :
-increase G : shift to the right
-Increase I : shift to the left
–> An increase in future output –> shifts the IS curve to the right
The Effects on an Expansionary Monetary Policy (IS-LMO
The effects on monetary policy on output depend very much on whether and how monetary policy affects expectations
See page 20 : image of IS- LM what do you notice?
The equilibrium moves from point A to point B, with higher output and a lower real interest rate. The steep IS curve, however, implies that the decrease in the current interest rate has only a small effect on output.
Monetary policy : If expectations about future interest rates and demand are unchanged, how is the effect on LM- IS)
the effect is small - from A to B (image page 20)
The effect on monetary depends particulary ?
The effects of monetary policyon output depend very much on whether and how monetary policy affects expectations.
Expectations of persistently low real interest rates (and high future demand, e.g. through forward guidance) stimulate current demand and output so that ? (image IS-LM page 20)
so that point C is attained
If a monetary expansion leads financial investors, firms, and consumers to revise their expectations of future interest rates and output, then …
the effects of the monetary expansion on output may be large.
–> But if expectations remain unchanged, the effects of the monetary expansion on output will be limited.
How do agents form expectations?
- Standard assumption (forward looking, rational)
- Alternative assumption (backward lookig, adaptive learning)
rational expectations definition
expectations formed in this forward-looking manner
The Effects of a Deficit Reduction on Current Output with expectation (page 26)
When account is taken of its effect on expectations, the decrease in government spend ing need not lead to a decrease in output.
backloading
The smaller the current cuts of government expenditures and the larger the cuts in the future, the stronger is the positive demand ect.
backloading can reduce what ?
the credibility of the deficit reduction because the largest cuts are postponed to the future
Debate of the crisis of the euro area
Advocates of quick consolidation of government finances:
- Fiscal multiplier probably small or even negative
-Net effect of consolidation on economic activity is positive if both the direct eect and the eect on expectations are taken into account
Opponents of quick consolidation of government nances:
-The fiscal multiplier is positive in an economy with slack capacity
- Deficit reduction implies a further fall in output, at least a slower recovery
How much of the reduction in the deficit is achieved by raising taxes and how much by cutting spending, may be important
If some government spending programs are perceived as “wasteful,” cutting these programs today will allow the government to cut taxes in the future. Expectations of lower future taxes and lower distortions could induce firms to invest today, thus raising output in the short run.
Deficit reduction
refers to the process of narrowing the gap between a government’s revenues (primarily from taxes) and its expenditures. When a government spends more than it collects, it runs a budget deficit. Deficit reduction aims to either cut down spending, increase revenues, or a combination of both to reduce the shortfall and eventually bring the budget closer to balance or surplus.
Effect of the announcement of a program of deficit reduction?
- the government has regained control, and that the future is less bleak than they anticipated.
-increase in spending and output - Lower interest rates for the government are likely to translate into lower interest rates for firms and people.
-Investors who thought that the government might default on the debt and were asking for a large risk premium may conclude that the risk of default is much lower and ask for much lower interest rates.
Adaptive expectation
assumed to adapt by raising their expectation for the value of the variable for the following period
Animal spirts
movement in investement that could not be explained by movements in current variables –> expectation were considered but were largely unexplained
The user cost and the level of investment are negatively correlated. Why ?
higher user costs reduce the expected returns on investment, making firms less likely to invest in new capital.
fluctuations in output who contribute ?
Investment and consumption contribute roughly equally to fluctuations in output.
user cost
the total cost of using a unit of capital for a period
When the user cost increases, it becomes more expensive for firms to use capital, which discourages..
investement
A credible central bank
is one that is trusted by the public, financial markets, and economic agents to follow through on its stated monetary policy objectives and commitments
Transitory interest
refers to a temporary or short-term interest rate that is expected to change or revert to a long-term trend after a certain period.
current output Y has decreased, What will happend ?
- Expected future output Y ′e decreased
-The government decreased current expenditures G
