1 of 32 households: consumption and labor supply decisionsthe life-cycle theory of consumptionthe...

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Households: Consumption and Labor Supply DecisionsThe Life-Cycle Theory of ConsumptionThe Labor Supply DecisionInterest Rate Effects on ConsumptionGovernment Effects on Consumption and Labor Supply: Taxes and TransfersA Possible Employment Constraint on HouseholdsA Summary of Household BehaviorThe Household Sector Since 1970

Firms: Investment and Employment DecisionsExpectations and Animal SpiritsProfit MaximizationExcess Labor and Excess Capital EffectsInventory InvestmentA Summary of Firm BehaviorThe Firm Sector Since 1970

Productivity and the Business Cycle

The Short-Run Relationship Between Output and Unemployment

The Size of the Multiplier

Lecture 11

Household and Firm Behavior in the

Macroeconomy: A Further Look

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Households: Consumption and Labor Supply Decisions

The Life-Cycle Theory of Consumption

life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their expectations of lifetime income.

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The Life-Cycle Theory of Consumption

permanent income The average level of a person’s expected future income stream.

In their early working years, people consume more than they earn. This is also true in the retirement years. In between, people save (consume less than they earn) to pay off debts from borrowing and to accumulate savings for retirement.

FIGURE 16.1 Life-Cycle Theory of Consumption

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The Labor Supply Decision

The Wage Rate

Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your consumption.

According to the substitution effect of a wage rate increase, a higher wage leads to a larger quantity of labor supplied—a larger workforce.

According to the income effect of a wage rate increase, if we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less.

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Prices

nominal wage rate The wage rate in current dollars.

real wage rate The amount the nominal wage rate can buy in terms of goods and services.

Households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions.

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Wealth and Nonlabor Income

nonlabor, or nonwage, income Any income received from sources other than working— inheritances, interest, dividends, transfer payments, and so on.

Holding everything else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume, both now and in the future.

An unexpected increase in nonlabor income will have a positive effect on a household’s consumption.

An unexpected increase in wealth or nonlabor income leads to a decrease in labor supply.

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Interest Rate Effects on Consumption

A rise in the interest rate leads me to consume less today and save more. This effect is called the substitution effect of an interest rate change.

There is also an income effect of an interest rate change on consumption. If a household has positive wealth and is earning interest on that wealth, a fall in the interest rate leads to a fall in interest income.

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Government Effects on Consumption and Labor Supply: Taxes and Transfers

TABLE 16.1 The Effects of Government on Household Consumption and Labor Supply

Income Tax Rates Transfer Payments

Increase Decrease Increase Decrease

Effect on consumption Negative Positive Positive Negative

Effect on labor supply Negative* Positive* Negative Positive

*If the substitution effect dominates.Note: The effects are larger if they are expected to be permanent instead of temporary.

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A Possible Employment Constraint on Households

Households consume less if they are constrained from working.

unconstrained supply of labor The amount a household would like to work within a given period at the current wage rate if it could find the work.

constrained supply of labor The amount a household actually works in a given period at the current wage rate.

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A Possible Employment Constraint on Households

In Keynesian theory, current income determinescurrent consumption. It is incorrect to think consumption depends only on income, at least when there is full employment. However, if there is unemployment, Keynes is closer to being correct because income is not determined by households. When there is unemployment, the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms.

Keynesian Theory Revisited

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A Summary of Household Behavior

The following factors affect household consumption and labor supply decisions:

Current and expected future real wage rates

Initial value of wealth

Current and expected future nonlabor income

Interest rates

Current and expected future tax rates and transfer payments

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The Household Sector Since 1970

Consumption

Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable goods.

FIGURE 16.2 Consumption Expenditures, 1970 I–2007 IV

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Housing Investment

Housing investment fell during the four recessionary periods since 1970. Like expenditures for durable goods, expenditures for housing investment are postponable.

FIGURE 16.3 Housing Investment of the Household Sector, 1970 I–2007 IV

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Labor Supply

Since 1970, the labor force participation rate for prime-age men has been decreasing slightly. The rate for prime-age women has been increasing dramatically. The rate for all others 16 and over has been declining since 1979 and shows a tendency to fall during recessions (the discouraged- worker effect).

FIGURE 16.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2007 IV

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Firms: Investment and Employment Decisions

Expectations and Animal Spirits

animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings.

The Accelerator Effect

accelerator effect The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output.

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Profit Maximization

inputs The goods and services that firms purchase and turn into output.

plant-and-equipment investment Purchases by firms of additional machines, factories, or buildings within a given period.

labor-intensive technology A production technique that uses a large amount of labor relative to capital.

capital-intensive technology A production technique that uses a large amount of capital relative to labor.

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Excess Labor and Excess Capital Effects

excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output.

adjustment costs The costs that a firm incurs when it changes its production level— for example, the administration costs of laying off employees or the training costs of hiring new workers.

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Inventory Investment

inventory investment The change in the stock of inventories.

Stock of inventories (end of period) = Stock of inventories (beginning of period)

+ Production - Sales

The Role of Inventories

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desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs).

The Optimal Inventory Policy

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A Summary of Firm Behavior

The following factors affect firms’ investment and employment decisions:

Firms’ expectations of future output

Wage rate and cost of capital (the interest rate is an important component of the cost of capital)

Amount of excess labor and excess capital on hand

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A Summary of Firm Behavior

The most important points to remember about the relationship among production, sales, and inventory investment are

Inventory investment—that is, the change in the stock of inventories—equals production minus sales.

An unexpected increase in the stock of inventories has a negative effect on future production.

Current production depends on expected future sales.

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The Firm Sector Since 1970

Plant-and-Equipment Investment

Overall, plant-and-equipment investment declined in the four recessionary periods since 1970.

FIGURE 16.5 Plant-and-Equipment Investment of the Firm Sector, 1970 I–2007 IV

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Employment

Growth in employment was generally negative in the four recessions the U.S. economy has experienced since 1970.

FIGURE 16.6 Employment in the Firm Sector, 1970 I–2007 IV

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The inventory/sales ratio is the ratio of the firm sector’s stock of inventories to the level of sales. Inventory investment is very volatile.

FIGURE 16.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2007 IV

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productivity, or labor productivity Output per worker hour; the amount of output produced by an average worker in 1 hour.

In general, employment does not fluctuate as much as output over the business cycle. As a result, measured productivity (the output- to-labor ratio) tends to rise during expansionary periods and decline during contractionary periods.

FIGURE 16.8 Employment and Output over the Business Cycle

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Productivity in the Long Run

Productivity figures can be misleading when used to diagnose the health of the economy over the short run, because business cycles can distort the meaning of productivity measurements. Output per worker falls in recessions because firms hold excess labor during slumps. Output per worker rises in expansions because firms put the excess labor back to work. Neither of these conditions has anything to do with the economy’s long-run potential to produce output.

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Okun’s Law The theory, put forth by Arthur Okun, that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts.

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discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, dropping out of the ranks of the unemployed and the labor force.

Let E denote the number of people employed, let L denote the number of people in the labor force, and let u denote the unemployment rate. In these terms, the unemployment rate is

u = 1 – E/L

The unemployment rate is 1 minus the employment rate, E/L.

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The Size of the Multiplier

The value of the multiplier in reality is smaller than the simple multiplier. We can now summarize why.

1. There are automatic stabilizers.2. The interest rate and the crowding-out effect.3. The effect of expansionary policy on the price

level.4. The fact that firms hold excess capital and

excess labor.5. There are inventories.6. There are people’s expectations.

In practice, the multiplier probably has a value of around 1.4. Its size also depends on how long ago the spending increase began.

The Size of the Multiplier in Practice

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accelerator effect

adjustment costs

animal spirits of

entrepreneurs

capital-intensive technology

constrained supply of labor

desired, or optimal, level of

inventories

discouraged-worker effect

excess capital

excess labor

REVIEW TERMS AND CONCEPTS

inputs

inventory investment

labor-intensive technology

life-cycle theory of consumption

nominal wage rate

nonlabor, or nonwage, income

Okun’s Law

permanent income

plant-and-equipment investment

productivity, or labor productivity

real wage rate

unconstrained supply of labor

1 of 32 households: consumption and labor supply decisionsthe life-cycle theory of consumptionthe...

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