Shocks and Consumption

Question 1

Household shock

Answer 1

good/bad fortune strikes a household

Question 2

economic-wide shock

Answer 2

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

Question 3

self-insurance

Answer 3

saving and borrowing, other households not involved

Question 4

co-insurance

Answer 4

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

Question 5

role of trust, reciprocity and altruism

Answer 5

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

Question 6

Consumption smoothing

Answer 6

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

Question 7

pure impatience

Answer 7

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

Question 8

Myopia

Answer 8

people experience the present satisfaction of hunger/other desires more strongly than they imagine they will imagine in future

Question 9

prudence

Answer 9

people know that they may not be around in future, so choosing present consumption is a good idea

Question 10

Pure impatience example

Answer 10

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

Question 11

Smoothing with borrowing

Answer 11

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

Question 12

Lifetime income and consumption smoothing

Answer 12

income starts low, rises when promoted and falls at retirement

consumption changes before income does (if individual can borrow)

Question 13

Response to unexpected shocks

Answer 13

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

Question 14

Smoothing and the economy

Answer 14

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

Question 15

Credit constraints

Answer 15

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

Question 16

Credit constraints and welfare

Answer 16

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

Question 17

Value of co-insurance

Answer 17

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

Question 18

Investment volatility

Answer 18

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

Question 19

Push factors

Answer 19

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

Question 20

Credit-constraints and firms

Answer 20

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

Question 21

Pull factors

Answer 21

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

Question 22

Circle of this pull factor

Answer 22

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

Question 23

Pull factors and game theory

Answer 23

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

Question 24

Investment, confidence, demand

Answer 24

• 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

Question 25

Consumption and investment fluctuations from data

Answer 25

• 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