Shocks and Consumption Flashcards
Household shock
good/bad fortune strikes a household
economic-wide shock
good/bad fortune strikes the entire economy
a shock is an unexpected event which causes GDP to fluctuate
co-insurance is less effective if bad shock hits everyone at the same time
but is more necessary as community survival requires that less badly hit households help the others
self-insurance
saving and borrowing, other households not involved
co-insurance
support from local network or government (unemployment benefits)
informal co-insurance (family and friends) based on reciprocity and trust: willing to help those who’ve helped you
altruism usually involved
these insurances reflect that households prefer to smooth their consumption and that they are altruistic
role of trust, reciprocity and altruism
people in regions with high year to year variability in rainfall and temp display high levels of trust, more con-insurance institutions such as unemployment benefits, gov assistance for disabled and poor
Consumption smoothing
people prefer to smooth consumption
there’s diminishing marginal returns to consumption: the value of an additional unit of consumption declines, the more consumption an individual has
an individual smoothes their consumption to avoid consuming a lot in one period and little in the other
pure impatience
a characteristic of a person who values an additional unit of consumption now over one later, when the amount of consumption is the same now and later
Myopia
people experience the present satisfaction of hunger/other desires more strongly than they imagine they will imagine in future
prudence
people know that they may not be around in future, so choosing present consumption is a good idea
Pure impatience example
At A: $50 now, $50 later
B: $49 now but would need $51.50 later to stay on the same indifference curve
so at B would need $1.50 later to compensate for losing $1 now
so more value on an additional unit of consumption today than in future
Smoothing with borrowing
when the interest rate is 10%, the highest attainable indifference curve will be the one that is tangent to the feasible frontier (on consumption now, later curve)
at this point MRS = MRT
if interest rate increases, feasible set gets smaller
Lifetime income and consumption smoothing
income starts low, rises when promoted and falls at retirement
consumption changes before income does (if individual can borrow)
Response to unexpected shocks
if the shock is permanent, adjust the path of consumption up or down to reflect the new long-run consumption consistent with the new pattern of forecast income
if the shock is temporary: little will change, a temporary fluctuation in income has almost no effect on lifetime consumption as only makes small change in lifetime income
Smoothing and the economy
consumption smoothing is a basic source of stabilisation in an economy
limitations to consumption smoothing mean it cannot always stabilise the economy, it could amplify initial shock
this is due to:
- lack of information (whether shock is temporary or permanent)
- credit constraints (can’t borrow)
- weakness of will: inability to commit to beneficial future plans (household can smooth consumption by saving but doesn’t and may regret it)
- limited co-insurance - a lot of households lack a network of friends and family that can help out
unemployment benefits provide some sort of co-insurance but in many societies the coverage of these policies is very limited
Credit constraints
a limitation of consumption-smoothing
a limit of amount borrowed/ability to borrow
in a normal household, consumption changes immediately after shock
in a credit-constrained household that can’t borrow has to wait until the income arrives before adjusting it’s standard of living
Credit constraints and welfare
an unconstrained household can choose any point on a budget constraint
when there’s an income shock they can borrow and repay in future
lower welfare for those constrained as they can’t borrow
Value of co-insurance
e.g Germany 2009
the demand for firms’ products fell
workers hours were cut
very few germans lost their jobs thanks to the governments policy and agreements between firms and employees
in the case of a negative shock such as the loss of a job, this means that the income shock will be passed on to other families who would have produced and sold the goods and services that are now not demanded
Investment volatility
firms don’t have preferences for smoothing like households
investment decisions depend on firm’s expectations about future demand to maximise their profits
therefore investment occurs in waves
pull and push factors can account for firm investments
Push factors
firms respond to profit opportunities by innovating
firms using the new tech. can produce output at lower costs or produce higher-quality output
so they expand their share of the market
- firms failing to do so fall out of business
- new tech means firms must install new machines
- leads to an investment boom
- which is amplified if firms producing new machinery need to expand their own production to meet extra demand
Credit-constraints and firms
another reason for the clustering of investment projects and the volatility of aggregate investment
- in a buoyant economy, profits are high and firms can use these profits to finance investments
access to external finance from sources outside the firm is also easier
Pull factors
investment by one firm can also pull others to invest
think of economy with 2 firms:
- Firm A’s machinery isn’t fully used so it can produce more if it hires more employees
- but not enough demand to sell the products it would produce (low capacity utilisation)
- the owners of firm A have no incentive to hire more workers/install more machinery
- Firm B has the same problem
Circle of this pull factor
low expectations of future demand leads to low capacity and low profits, so no incentive to invest or hire and so little spending by firms or workers
- if owners think that firms won’t invest, then they won’t invest
vicious cycle is self-reinforcing
if owners then invest and hire at same time
- employ more workers, who spend more, increasing the demand for the products of both firms
leads to a virtuous cycle:
- firms invest and hire, higher spending by firms and workers, higher demand for each firms products, high capacity and utilisation and higher profits
Pull factors and game theory
it’s a coordination game
2 Nash equilibria: virtuous and vicious cycle
no dominant strategy
(not invest, not invest) is not Pareto efficient
to make the move from the vicious to the virtuous cycle the firms have to coordinate
or develop business confidence about what the other will do
Investment, confidence, demand
- coordination corollary: investment spending will respond positively to the growth of demand in the economy
once an increase in aggregate spending on domestic production occurs, this helps to coordinate the forward-looking plans of firms and stimulates investments
the business confidence indicator moves closely with aggregate demand and investment
Consumption and investment fluctuations from data
- we expect consumption spending is smoother than GDP and investment spending more volatile that GDP
from data:
- investment more volatile than consumption
- investment and consumption are pro cyclical
- consumption is less volatile than GDP in rich countries
- consumption volatile in middle-income, credit-constrained households
- government spending is less volatile than investment (not dependent on business confidence)
it can be countercyclical is gov intervene during recessions
- exports depend on demand from other countries, so will fluctuate according to the business cycles of major export markets
