Consumption and investment

Question 1

Consumption hypothesis

Answer 1

Consumption of forward-looking consumer, depends on total wealth:
- financial wealth (value of checking and saving accounts, stocks and bonds net of liabilities)
- housing wealth (value of the house owned and other real estate net of mortgages)
- human wealth (PV of the after-tax labor income over the working life)

Question 2

Tobin’s Q

Answer 2

relationship between:
- stock market (valuation of an already invested unit of capital)
- purchase price for a new unit of capital

if stock market > purchase price, invest

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)

for selected countries: high correlation between investment and stock market
but: empirically current profits (CF) are more important than suggested by the PV (credit constraints?)

Question 3

Volatility of consumption and investment

Answer 3

in comparison to GDP: investment is more volatile, consumption is less volatile

Question 4

Why is the IS curve steeper?

Answer 4

a lower interest rate has a more minor effect on output, because:
- a fall in the current interest rate has no robust effect on expenditures unless it is accompanied by a fall in expected future interest rates
- if income changes only transitorily, the effect on consumption and investment is small

Question 5

expectations and expansionary monetary policy

Answer 5

• the effect of monetary policy strongly depends on whether expectations are affected and how
• if expectations about future interest rates and demand are unchanged, the effect is small
• expectations of persistently low real interest rates (and high future demand) stimulate current demand and output so that point C is attained

Question 6

Rational expectations and fiscal policy: deficit reduction

Answer 6

• deficit reduction does not have to reduce output if the effect on expectations is considered
• the smaller the current cuts of government expenditures and the larger the cuts in the future (backloading), the stronger the positive demand effect
• backloading can reduce the credibility of the deficit reduction because the largest cuts are postponed to the future

Question 7

the debate of the crisis of the euro area

Answer 7

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 effect and the effect on expectations are taken into account

opponents of quick consolidation of government finances:
- the fiscal multiplier is positive in an economy with slack capacity
- deficit reduction implies a further fall in output, at least a slower recovery