Consumption and investment Flashcards
How do households respond to fluctuations in income?
- self- insurance = household savings used to smooth consumption against temp income decrease
- co-insurance = pooled savings across households through informal insurance networks and govt insurance policies
Explain smoothing over the life-cycle
At start of career current income is lower than future income so savings are low and individuals are likely to borrow to fund current consumption, during employment e.g. post promotion income is higher than in the past, and higher than it will be in the future, so individual pays off debt from previous period and accrues savings, in retirement use savings from previous period to maintain consumption
What will a consumption smoothing household do when there is news of a future increase in income?
They will borrow today to bring forward and increase current consumption and repay the debt once the income increase has happened
What will a consumption constrained household do when there is news of a future increase in income?
Maintain path of consumption as they don’t have access to loans and so cannot increase consumption until the income increase happens
What is the slope of the household’s budget line?
negative gross interest rate
What is the concept of weakness of will in relation to consumption smoothing?
When a household knows of a future fall in income, they should reduce current consumption and increase saving in order to smooth future consumption. However iff the household are weak-willed they may struggle to decrease their current consumption and so in future they will have a greater decrease in consumption as they won’t have saved enough to smooth consumption
Why is investment volatile?
- No natural incentive to smooth investment
- New technologies
- Coordination problems
- Expectations
- Credit cycles
Explain the negative expectations of future demand vicious cycle?
Low expectations of future demand -> low capacity utilization/low profits -> no incentive to hire or invest -> little spending by firms or workers -> low expectations of future demand
Explain the positive expectations of future demand virtuous cycle?
High demand for firms product -> high capacity utilization/high profits -> firms invest and hire -> higher spending by firms and workers -> high demand for firms products
When investment is modeled as a game, what are the Nash equilibria?
Both firms invest OR both firms don’t invest
What are the 2 problems associated with firms borrowing in order to invest?
Moral hazard and adverse selection
Explain the credit cycle?
When firms have to pledge collateral in order to borrow, a decrease in assets’s collateral values affect the firms ability to borrow.
When firm A decreases investment, this lowers the price of investment goods (assets) which lowers firm Bs collateral reducing their ability to borrow, and so firm B reduces their investment (and cycle continues)
