Prepared by:

Fernando Quijano and Yvonn Quijano

2006 Prentice Hall Business Publishing

Macroeconomics, 4/e

CHAPTER 16
CHAPTER16

Expectations,
Consumption,
and Investment

Olivier

Chapter 16: Expectations, Consumption,

and Investment

16-1

Consumption

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.

Up Close and Personal: Learning from Panel Data

Sets

Panel data sets are data sets that show the value of one
or more variables for many individuals or many firms over
time.

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Chapter 16: Expectations, Consumption,

and Investment

The Very Foresighted Consumer

A very foresighted consumer who decides how

much to consume based on the value of his total
wealth, which comprises:
The value of his nonhuman wealth, or the
sum of financial wealth and housing wealth.
The value of his human wealth and nonhuman
wealth together gives an estimate of his total
wealth.

C ( to ta l w e a lth t )

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Chapter 16: Expectations, Consumption,

and Investment

An Example

Building on what you saw in Chapter 14, lets

compute the present value of your labor income
as the value of real expected after-tax labor
income, discounted using real interest rates.

V ( Y Le t T t e ) ( $ 4 0 , 0 0 0 ) ( 0 . 7 5 ) ( 7 2 . 2 ) $ 2 , 1 6 6 , 0 0 0
Your wealth today, the expected value of your
lifetime after-tax labor income, is around $2
million.

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Chapter 16: Expectations, Consumption,

and Investment

Toward a More Realistic Description

The constant level of consumption that a

consumer can afford equals his total wealth
divided by his expected remaining life.
Consumption depends not only on total wealth
but also on current income.

C
Y

Lt

C ( to ta l w e a lth t ,Y

LT

Tt)

real labor income in year t.

T t real taxes in year t.

Y L T T t human wealth, or the expected present
value of after-tax labor income

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Chapter 16: Expectations, Consumption,

and Investment

Toward a More Realistic Description

In words:
Consumption is an increasing function of total
wealth, and also an increasing function after-tax
labor income. Total wealth is the sum of
nonhuman wealth financial wealth plus housing
wealth and human wealth the present value
of expected after-tax income.

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Chapter 16: Expectations, Consumption,

and Investment

Putting Things Together: Current Income,

Expectations, and Consumption

Expectations affect consumption in two ways:

Directly through human wealth, or
expectations of future labor income, real
interest rates, and taxes.
Indirectly through nonhuman wealth - stocks,
bonds, and housing. Expectations of the
value of nonhuman wealth is computed by
financial markets.

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Chapter 16: Expectations, Consumption,

and Investment

Do People Save Enough

for Retirement?

Table 1

Mean Wealth of People, Age 6569, in 1991 (in thousands of 1991

dollars)

Social Security Pension

$100

Employer-provided pension

$62

Personal retirement assets

$11

Other financial assets

$42

Home equity

$65

Other equity

$34

Total

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$314

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Chapter 16: Expectations, Consumption,

and Investment

Putting Things Together: Current Income,

Expectations, and Consumption

This dependence of consumption on

expectations has two main implications for the
relation between consumption and income:
Consumption is likely to respond less than
one for one to fluctuations in current income.
Consumption may move even if current
income does not change.
Consumption may move even if current income
does not due to changes in consumer
confidence.

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Chapter 16: Expectations, Consumption,

and Investment

16-2

Investment

Investment decisions depend on current sales,

the current real interest rate, and on expectations
of the future.
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.

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Chapter 16: Expectations, Consumption,

and Investment

Investment and Expectations of

Profit
Depreciation:
The rate of depreciation, , measures how much
usefulness the machine loses from one year to
the next.
Reasonable values for are between 4 and 15%
for machines, and between 2 and 4% for
buildings and factories.

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Chapter 16: Expectations, Consumption,

and Investment

The Present value of

Expected Profits
V( et): The present value, in year t, of expected
profit in year t+1 equals:

1 rt
In year t+2,

1
(1 rt )(1 r

t1

t1

(1 )

t2

In year t,

1
V ( t)

1 rt
e

t1

1
(1 rt )(1 r

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t1

(1 )

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t2

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Chapter 16: Expectations, Consumption,

and Investment

The Present value of

Expected Profits
Figure 16 - 1
Computing the Present
Value of Expected
Profits

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Chapter 16: Expectations, Consumption,

and Investment

The Investment Decision

Denote It as aggregate investment, t as profit

per machine (or per unit of capital) for the
economy as a whole, and V(et) as the expected
present value of profit per unit of capital. This
yields the investment function:

I t I (V ( e t ) )
( )
In words: Investment depends positively on the
expected present value of future profits (per unit
of capital).

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Chapter 16: Expectations, Consumption,

and Investment

A Convenient Special Case

Suppose firms expect both future profits and

future interest rates to remain at the same level
as today, so that e t 1 e t 2
t

and

e
t1

e
t2

rt

Economists call such expectations

expectations that the future will be like the
present static expectations. Under these two
assumptions, we get
t
e

V (

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rt

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Chapter 16: Expectations, Consumption,

and Investment

Investment and the

Stock Market

Figure 1
Tobins q.
Versus the Ratio
of Investment to
Capital: Annual
Rates of
Change, 19601999

Tobins q denotes the variable corresponding to

the value of a unit of capital in place relative to its
purchase price.

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Chapter 16: Expectations, Consumption,

and Investment

A Convenient Special Case

Putting V (

e
and
I

I
(
V
(

t ))
rt
t
together give us an equation for investment:
t

It I

rt

The sum of the real interest rate and the

depreciation rate is called the user cost or the
rental cost of capital.
Therefore,
Rental Cost ( r t )

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Chapter 16: Expectations, Consumption,

and Investment

Current Versus Expected Profit

Investment depends on expected future profit,

but also moves strongly with fluctuations in
current profit.

I t I (V ( e t ) , t )
( , + )
Firms may be reluctant to borrow if current profit

is low. But if current profit is high, the firm may

not need to borrow to finance its investments.
Even if the firm wants to invest, it might have
difficulty borrowing. Potential lenders may not be
convinced the project is as good as the firms
says.

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Chapter 16: Expectations, Consumption,

and Investment

Current Versus Expected Profit

Figure 16 - 2
Changes in
Investment and
Changes in Profit in
the United States
since 1960

Investment and profit

move very much
together.

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Chapter 16: Expectations, Consumption,

and Investment

Profitability Versus
Cash Flow

Profitability refers to the expected present

discounted value of profits.
Cash flow refers to current profit, or the net flow
of cash the firm is receiving.
Both profitability and cash flow are important for
investment decisions, and are likely to move
together.

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Chapter 16: Expectations, Consumption,

and Investment

Profits and Sales

Figure 16 - 3
Changes in Profit
per Unit of Capital
Versus Changes in
the Ratio of Output
to Capital in the
United States since
1960

Profit and the ratio of

output to capital
move largely
together.

Yt

K t

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Chapter 16: Expectations, Consumption,

and Investment

The Volatility of
16-3
Consumption and Investment
Lets look at the similarities between our
treatment of consumption and of investment
behavior:
Whether consumers perceive current
movements in income to be transitory or
permanent affects their consumption
decisions.
In the same way, whether firms perceive
current movements in sales to be transitory or
permanent affects their investment decisions.

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Chapter 16: Expectations, Consumption,

and Investment

The Volatility of
Consumption and Investment
But there are also important differences between
consumption decisions and investment decisions:
When faced with an increase in income that
consumers perceive as permanent, they
respond with at most an equal increase in
consumption.
When firms are faced with an increase in
sales they believe to be permanent, their
present value of expected profits increases,
leading to an increase in investment.

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Chapter 16: Expectations, Consumption,

and Investment

The Volatility of
Consumption and Investment
Figure 16 - 4
Rates of Change of
Consumption and
Investment since
1960

Relative movements
in investment are
much larger than
relative movements in
consumption.

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Chapter 16: Expectations, Consumption,

and Investment

The Volatility of
Consumption and Investment
The figure yields three
conclusions:
Consumption and
investment usually
move together.
Investment is much
more volatile than
consumption.
Because, however, the
level of investment is
much smaller than the
level of consumption,
changes in investment
from one year to the
next end up being of the
same overall magnitude
as changes in
consumption.

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Chapter 16: Expectations, Consumption,

and Investment

Key Terms

permanent income theory of

consumption
life cycle theory of
consumption
panel data sets
financial wealth
housing wealth
human wealth

2006 Prentice Hall Business Publishing

nonhuman wealth
total wealth
Tobins q
static expectations
user cost of capital, or rental cost
of capital
profitability
cash flow

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