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Consumption and investment

Discuss the macroeconomic implications of microeconomic decision making by households and firms.

Explain the determinants of personal consumption.

Explain the determinants of private investment.

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Learning Objectives
After studying this chapter, you should be able to:
16.1

16.2
16.3

Are all tax cuts created equal?

Suppose the president and Congress enact a tax cut in order to increase growth and real GDP, and reduce unemployment.

You will receive an extra $80 per month in your paycheck.

What will you do with the money?

Spend all of it?

Save all of it?

Spend some and save some?

Will your decision depend on whether the tax cut is temporary or permanent?

Permanent tax cuts generally lead to more spending than temporary ones.

But permanent tax cuts reduce revenue by more.

In this chapter, we will look more closely at how households and firms make their decisions about consumption and investment.

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Households and firms make decisions about how much to consume and invest based on expectations about the future.

How does government tax policy affect the decisions of households and firms?

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Key Issue and Question

Issue:

Question:

Discuss the macroeconomic implications of microeconomic decision making by households and firms.

16.1

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Learning Objective

Intertemporal choice

Key decisions affecting GDP are made at the microeconomic level.

Individual choices do not matter much to overall GDP.

The aggregate decisions of all households and firms are important to overall GDP.

Economists generally assume two things about households and firms:

Households and firms act rationally to meet their objectives.

Households maximize utility, firms maximize profits.

Households and firms are forward looking.

Today’s decision to consume or save is a decision about when to consume. Today’s savings can be consumed in the future.

Expectations about the future affect consumption decisions today.

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A key difference between consumption and investment

While households and firms are forward-looking, their behavior is quite different.

Volatility of investment is much greater than consumption.

Growth rates for real personal consumption and real gross private investment, 1990-2012

Figure 16.1

During recessions, investment often falls substantially.

But consumption falls by less, and sometimes even rises during recessions.

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Explain the determinants of personal consumption.

16.2

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Learning Objective

Consumption and GDP

Household consumption, as a percentage of GDP, averages 61.5% across the world—80% in low-income countries.

Consumption in the U.S. was 61% of GDP in 1961, but rose to over 71% of GDP by 2011.

Consumption around the world

Figure 16.2

Why? Not one clear answer, but increases in wealth and access to credit are two likely causes.

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U.S. growth in different types of consumption

Some types of consumption are more volatile than others.

Durable goods expenditure is much more volatile than spending on nondurable goods and services.

Expenditures on health care and nondurable goods like clothing is less volatile.

Growth rates in real expenditure on durable goods, nondurable goods, and services, 1990-2012

Figure 16.3

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The intertemporal budget constraint

Consider a simple model of consumption:

Two time periods (year 1 and year 2).

No government (no transfer payments, taxes).

Unlimited borrowing or saving at real interest rate r.

Receive income Y1 this year, Y2 next year.

Consume C1 this year, C2 net year.

Income this year is partially spend on consumption and partially saved:

If S1 is positive, you save some money for next year; if it is negative, you borrow some money and repay (with interest) it next year. Next year, you can consume:

Then:

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The intertemporal budget constraint

This is known as the intertemporal budget constraint.

Intertemporal budget constraint A budget constraint that applies to consumption and income in more than one time period; it tells us how much a household can consume, given lifetime income.

The left side of the equation shows lifetime consumption; the right side, lifetime income.

Suppose the real interest rate were zero; then the intertemporal budget constraint would simply be:

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Two theories of consumption smoothing

Economists believe (and observe!) that people engage in consumption smoothing—that is, they try to keep changes in consumption relatively small across time periods.

Two different theoretical justifications:

Permanent income hypothesis

Developed by Nobel Laureate Milton Friedman

Life cycle hypothesis

Developed by Nobel Laureate Franco Modigliani

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The permanent income hypothesis

Permanent-income hypothesis The hypothesis that household consumption depends on permanent income and that households use financial markets to save and borrow to smooth consumption in response to fluctuations in transitory income.

Permanent income Income that households normally expect to receive each year.

Transitory income Income that households do not expect to receive each year.

Suppose at your job you receive a salary (YPermanent) that is consistent from year to year, and a bonus (YTransitory) that changes.

Milton Friedman argued that your consumption would be based on YPermanent:

where a is a constant reflecting the percentage of permanent income households consume.

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Implications of the permanent income hypothesis

Friedman argued if someone received an unexpected windfall, such as a temporary tax cut, they would view most of the income as transitory and save a large share of it.

If someone receives a better job with better pay, their permanent income rises and they would consume more.

Consumption responds more to changes in permanent income than to changes in transitory income.

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The life-cycle hypothesis

Life-cycle hypothesis The theory that households use financial markets to borrow and save to transfer funds from high-income periods, such as working years, to low-income periods, such as retirement years or periods of unemployment.

Consumption, income, and saving over the life cycle

Figure 16.4

According to this theory, people anticipate having high and low incomes over their lives, and borrow/save in order to smooth out their consumption.

The goal of saving is to provide for future consumption.

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The life-cycle hypothesis

Suppose you have some initial wealth, and expect to live for N years. You will work for B of those years, earning Y per year. Then, assuming the real interest rate was zero, you can spend in total:

The life-cycle hypothesis says you will spread this out over your lifetime; you will consume 1/N of this each year:

Here, is the marginal propensity to consume out of wealth

is the marginal propensity to consume out of income

Marginal propensity to consume (MPC) The amount by which consumption increases when disposable income increases by $1.

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Implications of the life-cycle hypothesis

If N = 50, and a person will work for 40 additional years (B = 40), the MPC = 0.8.

Person consumes $80 for each additional $100 in income.

These income increases are considered permanent.

Transitory changes to income will change consumption patterns less.

The same person would consume only $2 out of every additional $100 of wealth.

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Do households really smooth consumption?

Households should smooth consumption if our microeconomic theories about the utility of consumption are correct.

Diminishing marginal utility of income in any given period.

Therefore transfer income from “rich” periods to “poor” periods.

Many economists have found strong evidence of consumption smoothing for aggregate consumption.

Households smooth consumption of services and nondurables more than they do for durables.

People have more flexibility on when to replace durables like cars and appliances, than nondurables and services.

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Permanent vs. transitory changes in income

Assume you are a 20 year old, with zero wealth, expecting to work until age 60 and expecting to live to age 70. If you earn a constant salary of $50,000:

You earn $2 million over your working life, consuming $40,000 per year and saving $10,000 per year. If you receive a $10,000 transitory increase to your income in your first year of work, your lifetime income is now $2.01 million.

Consumption rises to $2,010,000/50 = $40,200

Completely smoothing income, the transitory MPC is calculated as

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Permanent vs. transitory changes in income

If your annual salary increased to $60,000 per year for all years

Consumption would rise to $2,400,000/50 = $48,000

Completely smoothing income, the permanent income MPC is:

The MPC for permanent income is much higher than for transitory income.

Policymakers need to take this into account when trying to use tax changes to increase consumption.

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Consumption and the real interest rate

Households smooth consumption by borrowing or selling financial assets when income is low, and saving when income is high.

Real interest rates impact consumption decisions.

Changes in the real interest rate have:

Substitution effects through the “price” of consumption.

Increase in the real interest rate makes current consumption more expensive.

Income effects by impacting household incomes.

We will describe these on the next slide; but in general, we will assume that the substitution effect is strongest; so increases in the real interest rate will decrease current consumption.

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Consumption and the real interest rate

Higher real interest rates make consumption more “expensive” this year.

The real interest rate is the price of current consumption relative to future consumption.

This substitution effect shows that individuals reduce current consumption and increase future consumption when the real interest rate rises.

Income effects move in the same direction as the substitution effect for net borrowers, but in the opposite direction for net lenders.

The table shows the effect of an increase in the real interest rate on current-period consumption:

The effect of the real interest rate on consumption

Table 16.1

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Housing wealth and consumption

Both wealth and income are important to consumption decisions.

Homes are important assets for many households.

The CBO estimates that a $1 increase in housing wealth increases consumption expenditures by $0.07.

Other research suggests this estimate is too high.

Decreases in housing wealth do not seem to change aggregate consumption expenditures. Why?

Decreases in housing prices hurt some households but help others.

Whether aggregate consumption rises or falls depends on the mix of households and the MPC out of wealth for each group.

Decrease in home prices during 2007-2009 recession had likely a small impact on consumption, but a large impact on financial markets and the residential construction industries.

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How policy affects consumption

Government policy impacts disposable income today and in the future.

Permanent increases in annual taxes, with no increase in expected transfer payments would lead to a decline in consumption and savings.

The tax increase represents a change in permanent income.

Summary of factors that affect household consumption

Table 16.2

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Effects of a temporary tax cut on consumption

President Obama and Congress temporarily reduced the payroll tax, beginning in 2011.

Should this temporary tax cut have had a large effect on consumption?

We can gain some insight by continuing with our previous example in which you are 20 years old, you plan to work for 40 years at an after-tax salary of $40,000, and you expect to live to age 70.

Assume that your initial wealth is zero.

Now suppose the government gives you a one-time tax rebate of $1,000 during your first year of work.

Predict the effect of the tax rebate on your consumption.

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Solved Problem

Effects of a temporary tax cut on consumption

Step 1 Review the chapter material.

Step 2 Determine the effect on your lifetime disposable income. Your lifetime disposable income is now.

Step 3 Show the effect of the tax cut if you smooth consumption. If you smooth consumption completely, then you have the following:

Step 4 Compare your new level of consumption to your initial level of consumption. You consumed $32,000 per year and saved $8,000 per year before the one time tax break. Now you consume $32,020, and save $8,980 during the first year. You smooth the additional $1,000 over your remaining 50 years. The transitory increase in disposable income has a small impact on consumption.

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Solved Problem

Asymmetric information problems in lending

The theory of consumption smoothing assumes perfectly functioning capital markets.

When financial markets do not work perfectly, households face constraints on how much they can borrow.

Asymmetric information problems between borrowers and lenders.

Lenders can raise the real cost of borrowing.

But then safer borrowers drop out of the market, leaving a riskier overall pool.

Lenders also may require collateral on many loans in order to ease the asymmetric information problem.

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Credit rationing of households

If households are credit rationed, the MPC of disposable income is high.

Households would like to borrow, but cannot.

When they have an increase in disposable income, they spend most of the increase to approach the preferred level of consumption.

If many households are credit constrained, temporary changes to income can have large effects on aggregate consumption.

Economists have found evidence suggesting credit rationing is an important determinant of household consumption.

Example: Changes in credit card limits have a large effect on houw much debt households accumulate.

Other evidence suggests the impact of credit rationing is not that large.

80% of consumption expenditures are consistent with consumption smoothing model.

Remainder of consumption expenditures are consistent with credit rationing.

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Implications of credit rationing

Credit rationing has important implications for government policy.

If credit rationing is important, temporary tax cuts should have large effects on consumption

During recession of 2007-2009, credit card companies played an important role:

Initially, companies continued to increase credit limits; so households could still smooth consumption. That is, consumption fell little in response to the recession.

In September and October 2008, companies began to reduce borrowing limits.

Happened at the same time that home values were declining.

Spending on consumer durables decreased significantly as a result.

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The temporary cut in payroll taxes

In 2011, workers paid 12.4% tax on the first $106,800 of salary for Social Security.

Half the tax is paid by employers and the other half is explicitly paid by employees.

The government reduced the employee share by 2% to 4.2% for one year.

For someone earning $70,000 a year, the payroll-tax cut increased disposable income by $1,400.

Supporters believed disposable income would increase for 155 million workers, leading to increased consumption and real GDP.

Disproportionately received by low- and middle-income workers.

Impact may also accrue to credit-rationed households.

Estimates by Deutsche Bank predicted a 0.7% increase in GDP in 2011.

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Making the Connection

The temporary cut in payroll taxes

However, according to our theories, transitory tax cuts should have relatively little effect on consumption.

Households may save the tax cut instead of spending it.

2001 and 2008 tax rebates appear to have been partially saved by households.

Of course, the payroll tax cuts also reduce government revenue for paying Social Security checks, worsening fiscal problems.

Another concern: may be politically difficult to allow tax holiday to expire.

Overall effect of payroll tax cuts is difficult to determine, and will be the subject of research for years to come.

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Making the Connection

Precautionary saving

Saving acts as insurance against unexpected events.

Increased probability of job loss will lead to increased precautionary savings.

Precautionary saving Extra saving by households to protect themselves from unexpected decreases in future income due to job loss, illness, or disability.

Households can be viewed as having a desired level of wealth.

Wealth above desired level, consumption rises, wealth falls.

Wealth below desired level, consumption falls, wealth rises.

Increased uncertainty about the future increases the desired level of wealth, leading to lower consumption.

Research shows nearly half of household net worth may be due to precautionary saving; therefore precautionary saving is very important for the economy.

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Tax incentives and saving

The after-tax real interest rate determines how households manage current and future consumption.

Taxes on income from savings reduce the real after-tax interest rate.

Reduces the incentive to save, increasing consumption.

Two federal programs reduce taxes and increase the after-tax real interest rate, by allowing savers to defer paying taxes until withdrawal of funds:

Traditional individual retirement accounts (IRAs).

Employer-sponsored 401(k) plans.

Difficult to tell if tax incentives lead to additional savings, or shifting of savings from non-tax preferred to tax-preferred accounts.

Tax incentives may be paid for using budget deficits.

Glenn Hubbard and Jonathan Skinner: $1 of reduction in tax revenue from savings results in increases in private capital stock of $5 (for IRAs) and $17 (for 401(k) plans)—large and significant effects.

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Explain the determinants of private investment.

16.3

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Learning Objective

Gross capital formation

The figure shows gross capital formation—a measure of investment—as a percentage of GDP.

In 2010, U.S. invested 15% of GDP compared with 18% for other high-income countries.

Gross capital formation around the world

Figure 16.5

Many countries experiencing high growth rates have been investing large proportions of their income.

China: 48% of GDP

India: 35% of GDP (2010 figures)

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Comparing volatility of types of investments

We know investment is more volatile than consumption; but some categories of investment are more volatile than others.

Before the Great Moderation, residential investment expenditures were more volatile than nonresidential or spending on equipment and software.

Growth rates for types of investments, 1975-2012

Figure 16.6

Since the Great Moderation, all investment categories have about the same volatility.

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The investment decisions of firms

Firms seek to maximize profits; in order to do so, they have an optimal choice of the size of their capital stock.

Desired capital stock The level of capital stock that maximizes a firm’s profits.

Three types of costs to compare to the benefits of additional capital.

Price of the capital goods.

Cost of depreciation.

Interest payments to finance the purchase of capital.

Tax policy impacts after-tax profits and the cost of capital.

Deduction of interest payments and capital depreciation before taxes encourages investment.

Benefits to purchasing capital accrue in the future.

Certain costs such as depreciation also lie in the future.

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The marginal product of capital

Marginal product of capital (MPK) The extra output a firm receives from adding one more unit of capital, holding all other inputs and efficiency constant.

Each additional unit of capital is less productive than the ones before—due to the law of diminishing marginal returns.

With the price (marginal cost) of using capital constant or rising, firms can find their optimal level of capital to maximize profit.

In doing so, they consider the MPK over the entire life of the capital good.

Example: Ford must consider what will happen to the demand for automobiles over the life of an assembly plant.

Also must anticipate taxes etc. that also affect MPK.

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Animal spirits

The decision about employing capital we described was how a rational firm would decide.

But what if firms are not fully rational?

Animal spirits Periods of irrational pessimism and optimism that affect the investment behavior of firms.

In his General Theory, Keynes argues that firms are sometimes overtaken by periods of irrational pessimism (low expected MPK) or irrational optimism (high expected MPK).

Example: Dot-com bubble of the late 1990s.

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The user cost of capital

The user cost of capital (uc) The expected real cost to a firm of using an additional unit of capital during a period of time.

User cost of capital consists of the real price of a capital good, the real interest cost of borrowing, and depreciation costs.

Most firms do not affect the price of capital (pk) or the real interest rate (r).

Depreciation rates (d) are determined by technology.

The user cost of capital is the sum of the interest cost and the depreciation cost s of capital.

uc = rpK + dpK = (r + d)pK

User cost of capital does not change as the capital stock changes since firms are small relative to the overall market.

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The desired capital stock

The desired capital stock (K*) maximizes profits where the expected MPK equals the user cost of capital.

The desired capital stock

Figure 16.7

The expected MPK curve slopes downward due to diminishing marginal returns.

With more capital than K*, the benefit of the last unit of capital is less than the cost.

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A change in the desired capital stock

The desired capital stock (K*) maximizes profits where the expected MPK equals the user cost of capital.

A decrease in the expected marginal product of capital and the desired capital stock

Figure 16.8

If firms expect demand for their products to fall, then expected output declines, shifting the MPK curve to the left.

The desired capital stock declines as a result of pessimistic outlook.

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A change in the desired capital stock

The desired capital stock (K*) maximizes profits where the expected MPK equals the user cost of capital.

An increase in the user cost of capital and the desired capital stock

Figure 16.9

Increases to the real interest rate raise the user cost of capital.

User cost of capital rises, leading to a reduction in desired capital stock.

Lower desired capital stock leads to a reduced level of output.

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Corporate taxes and the desired capital stock

Firms base their decision-making on the expected after-tax profits.

Changes in the tax-rate, therefore, change the profitability of projects—including adjusting the capital stock.

Firms now equate the after-tax MPK and the user cost of capital:

That is,

The term on the right hand side is the tax-adjusted user cost of capital.

Tax-adjusted user cost of capital The after-tax expected real cost to a firm of purchasing and using an additional unit of capital during a period of time.

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A change in corporate tax rates

If the government raises the corporate income tax rate, the tax-adjusted user cost of capital increases.

The desired capital stock decreases.

An increase in the tax-adjusted user cost of capital and the desired capital stock

Figure 16.10

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How important are corporate tax rates for firms?

Corporate taxes may have an important effect on the desired capital stock, and therefore aggregate investment expenditures.

Jason Cummins, Kevin Hassett, and Glenn Hubbard conducted estimates of major tax reforms on firm investment expenditures for 14 countries.

Found that in 12 of the 14 countries a reduction in corporate income taxes significantly increased the level of corporate investment activity.

Also examined decreases in the corporate income tax rates in the U.S. from 1962 to 1988.

Found that after every major tax reform during this period, there was a significant change in investment expenditure.

Investment is an important determinant of labor productivity. Reductions in the corporate tax rate may therefore raise the standard of living.

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Macro Data

Summary of factors affecting the size of capital stock

Factors that affect the desired capital stock

Table 16.3

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Summary of factors affecting the size of capital stock

Factors that affect the desired capital stock—continued

Table 16.3

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From transitory tax cuts to tax reform

President Obama signed a tax cut package in December 2010 increasing from 50% to 100% the fraction of the cost of capital goods that firms can deduct from taxable income in 2011.

Tax-adjusted user cost of capital should have decline.

Theory predicts the desired capital stock will rise, leading to more investment, higher GDP, and increased employment.

Anecdotal evidence suggests it had the desired effect.

Drawback: temporary tax cuts increase the complexity of the tax code.

Firms are uncertain about future tax policy.

The number of temporary tax breaks has increased from a dozen or so in the late 1990s to 141 in 2011.

Tax uncertainty may motivate firms to relocate overseas.

Many economists are urging policymakers to consider fundamental tax reform to simplify the tax code: reducing marginal tax rates while eliminating deductions and credits.

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Making the Connection

From the desired capital stock to investment

Capital goods produce goods and services that generate profits for firms.

With too little capital stock, firms cannot produce enough to maximize profits.

With too much capital stock, spends too much to maintain, leading to suboptimal profits.

Unexpected events affect the desired capital stock.

Improved technology leads to higher future production.

Large income tax increases lead to lower future profits.

But capital stock is costly to adjust.

Firms may eliminate a constant fraction (z) of the gap between desired and actual capital stock each period. (0 < z < 1)

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Depreciation, taxes, and investment spending

In December 2010, President Obama signed into law a bill that, among other things, increased the fraction of investment spending that firms are allowed to depreciate for tax purposes from 50% to 100

This provision effectively reduces the tax rate on investment projects for the year 2011.

What effect should this provision have had on the desired capital stock and the level of investment in 2011?

Draw a graph to illustrate your answer.

Should this provision have stimulated the economy in 2011?

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Solved Problem

Depreciation, taxes, and investment spending

Step 1 Review the chapter material.

Step 2 Determine the effect on the desired capital stock. Allowing firms to deduct 100% of investment expenditures from taxable income reduces the tax rate, and the tax-adjusted user cost of capital curve shifts down from uc1 to uc2.

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Solved Problem

Depreciation, taxes, and investment spending

Step 3 Explain whether this tax provision helped to stimulate the economy. The equation for investment tells us how investment spending responds to the desired capital stock.

An increase in the desired capital stock means the gap between desired capital stock and yesterday’s capital stock has increased. Firms will increase investment spending today to try and increase the capital stock to the desired level.

Increasing the amount of investment firms can deduct from taxable income should lead to increases in investment spending. However this would also increase the budget deficit holding all else fixed, which may offset at least some of the short-run impact of the tax cut by decreasing potential GDP.

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Solved Problem

Tobin’s q: another framework for explaining investment

James Tobin developed a theory of investment linking the level of investment to the stock market.

Tobin’s q The ratio of the market value of a firm to the replacement cost of its capital.

A firm’s market value is the stock price multiplied by the number of shares.

Apple Inc., for example, had about 1 billion shares outstanding in mid-2012, priced at $640 a share, for a total of $640 billion market value.

Apple has stock of capital goods valued at around $80 billion.

Tobin’s q for Apple, would be $640/$80 = 8.

The market values Apple’s capital at about eight times what it would cost Apple to purchase the capital.

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Tobin’s q

If Tobin’s q is greater than 1, the market value is greater than the cost to the firm of acquiring capital.

This represents a signal that it is profitable for the firm to acquire more capital goods and expand production.

If Tobin’s q is less than 1, the market value is less than its replacement cost, so the firm should decrease its capital stock.

Important link between financial markets and investment.

Stock prices are indicators of the expected future profits of a firm.

If expected future profits rise, the stock price will rise, Tobin’s q will increase, and the firm should increase investment activity.

Stock prices are volatile because expectations about future profitability of firms are also profitable.

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Credit rationing and the financial accelerator

Firms can either fund investment from their own financial resources or turn to financial markets.

Financial markets do not work perfectly for firms.

Asymmetric information problems.

Banks cannot perfectly observe financial state of firms.

Higher interest rates cause good borrowers to drop out of market.

So some firms are credit rationed and cannot pursue some profitable investment projects.

The financial accelerator is the dependence of investment expenditure on the state of the economy.

Demand shocks reduce profits.

Credit-rationed firms are forced to cut back on investment.

As markets worsen, the value of collateral for borrowing deteriorates.

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Uncertainty and irreversible investment

Once an investment project is finished, it is hard for the firm to use the investment for another activity.

Firms have the option of waiting to invest.

Increasing uncertainty about future output prices, input prices, interest rates, or regulation delays investment projects.

The sooner a firm invests, the sooner they can begin profiting from the investment.

Aggregate shocks, like oil prices or monetary policy, increase uncertainty, and reduce investment activity.

The fact that investments are irreversible and can be delayed makes the growth rate of investment expenditures prone to wide swings.

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Answering the key question

“How does government tax policy affect the decisions of households and firms?”

Temporary tax cuts and tax rebates are likely to have smaller effects on consumption than are permanent changes in taxes.

But if a large number of households are credit rationed, however, even temporary tax cuts can have a significant effect on consumption.

Corporate taxes increase the tax-adjusted user cost of capital, which reduces the desired capital stock.

So decreases in corporate taxes can help stimulate the economy during economic downturns because the decreases lead firms to increase their investment in order to increase their capital stock.

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