Consumption and investment

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Consumption and investment

  1. 1. Expectations, Consumption, and Investment
  2. 2. Consumption <ul><li>The theory of consumption was developed by Milton Friedman in the 1950s, who called it the permanent income theory of consumption , and by Franco Modigliani, who called it the life cycle theory of consumption . </li></ul>
  3. 3. The Very Foresighted Consumer <ul><li>A very foresighted consumer who decide how much to consume based on the value of his total wealth , which comprises: </li></ul><ul><ul><li>The value of his nonhuman wealth , or the sum of financial wealth and housing wealth . </li></ul></ul><ul><ul><li>The value of his human wealth , or the present value of expected after-tax labor income. </li></ul></ul>
  4. 4. Toward a More Realistic Description <ul><li>The constant level of consumption that a consumer can afford equals his total wealth divided by his expected remaining life. </li></ul><ul><li>Consumption depends not only on total wealth but also on current income. </li></ul>human wealth, or the expected present value of after-tax labor income real taxes in year t . real labor income in year t .
  5. 5. <ul><ul><li>Wealth </li></ul></ul><ul><ul><li>Consumer and saving habits </li></ul></ul><ul><ul><li>Size of the population </li></ul></ul><ul><ul><li>Income distribution </li></ul></ul><ul><ul><li>Credit availability </li></ul></ul><ul><ul><li>Expectations of change in prices </li></ul></ul><ul><ul><li>Expectations of future income </li></ul></ul><ul><ul><li>Interest rates </li></ul></ul>Shifts in the consumption function
  6. 6. <ul><li>Educational attainment of the head of the family and its members </li></ul><ul><ul><li>Family size </li></ul></ul><ul><li>Household Savings: </li></ul><ul><ul><li>Income (permanent and transitory) </li></ul></ul><ul><ul><li>Interest rates </li></ul></ul><ul><ul><li>Exchange rates (real effective exchange rates) </li></ul></ul><ul><ul><ul><li>Depreciation of the RUPEE </li></ul></ul></ul><ul><ul><ul><li>Appreciation of the RUPEE </li></ul></ul></ul>Determinants of family income:
  7. 7. <ul><li>Engel’s Law (Ernst Engel) </li></ul><ul><ul><li>There is a relationship between the amount of income and proportionate changes in consumption expenditures as income level shifts. </li></ul></ul><ul><ul><li>As the income of the family increases: </li></ul></ul><ul><ul><ul><li>A smaller percentage is spent for food </li></ul></ul></ul><ul><ul><ul><li>Approximately the same for clothing </li></ul></ul></ul><ul><ul><ul><li>Constantly increasing percentage spent for education, health, recreation, amusement, travel </li></ul></ul></ul><ul><ul><ul><li>Approximately the same percentage for rent, fuel and light. </li></ul></ul></ul>
  8. 8. Putting Things Together: Current Income, Expectations, and Consumption <ul><li>Expectations affect consumption in two ways: </li></ul><ul><ul><li>Directly through human wealth, or expectations of future labor income, real interest rates, and taxes. </li></ul></ul><ul><ul><li>Indirectly through nonhuman wealth—stocks, bonds, and housing. Expectations of the value of nonhuman wealth is computed by financial markets. </li></ul></ul>
  9. 9. Putting Things Together: Current Income, Expectations, and Consumption <ul><li>Consumption is likely to respond less than one for one to fluctuations in current income. </li></ul><ul><ul><li>Consumption may decrease one for one with a decrease in income only if the decrease in income is considered to be permanent. </li></ul></ul><ul><ul><li>Temporary changes in current income, such as those caused by recessions and expansions, are unlikely to increase consumption by as much as income. </li></ul></ul><ul><li>Consumption may move even if current income does not due to changes in consumer confidence. </li></ul>
  10. 10. Investment <ul><li>Gross Investment </li></ul><ul><ul><li>= Net Investment + Depreciation </li></ul></ul><ul><li>Investment (flow variable) </li></ul><ul><ul><li>Durable equipment, new buildings, increase in inventories </li></ul></ul><ul><li>Capital (stock variable) </li></ul><ul><ul><li>Equal to the amount of accumulated investment as of a given point in time. </li></ul></ul>
  11. 11. Investment <ul><li>Investment decisions depend on current sales, the current real interest rate, and on expectations of the future. </li></ul><ul><li>The decision to buy a machine depends on the present value of the profits the firm can expect from having this machine versus the cost of buying it. </li></ul>
  12. 12. <ul><li>Determinants of Investment: </li></ul><ul><ul><li>Business Investment in durable equipment </li></ul></ul><ul><ul><ul><li>Rate of profit </li></ul></ul></ul><ul><ul><ul><li>Interest rate </li></ul></ul></ul><ul><ul><ul><li>Changes in expectations </li></ul></ul></ul><ul><ul><ul><li>Rate of innovation </li></ul></ul></ul><ul><ul><ul><li>Rate of change in output </li></ul></ul></ul><ul><ul><li>Inventory Investment </li></ul></ul><ul><ul><ul><li>Rate of increase in sales </li></ul></ul></ul><ul><ul><li>Residential construction </li></ul></ul><ul><ul><ul><li>Change in income levels </li></ul></ul></ul><ul><ul><ul><li>Cost of construction </li></ul></ul></ul><ul><ul><ul><li>Availability and cost of housing credit </li></ul></ul></ul>
  13. 13. Investment and Expectations of Profit <ul><li>Depreciation : </li></ul><ul><li>The rate of depreciation, measures how much usefulness the machine loses from one year to the next. </li></ul><ul><li>Reasonable values are between 4 and 15% for machines, and between 2 and 4% for buildings and factories. </li></ul>
  14. 14. Investment and the Stock Market <ul><li>James Tobin argued that there should be a tight relation between the stock market and investment. </li></ul><ul><li>The stock price tells firms how much the stock market values each unit of capital already in place; thus, the willingness to pay for one more unit. If the stock market value exceeds the purchase price, the firm should buy the machine. </li></ul>
  15. 15. Profitability Versus Cash Flow <ul><li>Profitability refers to the expected present discounted value of profits. </li></ul><ul><li>Cash flow refers to current profit, or the net flow of cash the firm is receiving. </li></ul><ul><li>Both profitability and cash flow are important for investment decisions, and are likely to move together. </li></ul>
  16. 16. The Volatility of Consumption and Investment <ul><li>Investment is more volatile than consumption. </li></ul><ul><li>Consumption and investment usually move together. Both components contribute roughly equally to fluctuations in output over time. </li></ul>

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