978-0133780581 Chapter 15 Lecture Note

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Chapter 15. Expectations, Consumption,

and Investment

I. MOTIVATING QUESTION

How do expectations about the future influence consumption and investment?

If consumers are forward-looking and resources can be transferred across time through borrowing and

lending, then consumption should depend on wealth, rather than on income. Wealth includes the present

value of expected future income, financial wealth, and housing wealth. Although income fluctuates over

time, consumers, in principle, can maintain relatively constant consumption by borrowing when income is

low and saving when income is high. To the extent that consumers are unable or unwilling to borrow

when income is low, however, consumption will depend not only on wealth, but also on current income.

A firm decides to invest in a project when the present value of expected profit from the project exceeds its

cost. Therefore, investment depends on expected future profit. In practice, the ability and desire of firms

to borrow to finance investment may be limited when current profit is low. High current profit eliminates

the need to borrow to finance investment. Therefore, investment depends in part on current profit and in

part on the present value of expected profit from a new project.

II. WHY THE ANSWER MATTERS

The discussion of economic fluctuations in the Core ignored the role of expectations. This chapter

provides basic theoretical results about the role of expectations in consumption and investment behavior.

Chapter 17 uses these results to incorporate expectations into the IS–LM model.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The chapter introduces in passing the terms permanent income theory of consumption and life

cycle theory of consumption to describe the consumption theory discussed in this chapter.

ii. Human wealth is the present value of expected after-tax labor income.

iii. Tobin’s q is the ratio of a firm’s financial value—the value of existing stock plus the value of bonds

outstanding—to the replacement cost of the firm’s capital. Theory and evidence suggest that Tobin’s q

should be positively related to investment.

iv. The user or rental cost of capital is the sum of the real interest rate and the depreciation rate on a

unit of capital.

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IV. SUMMARY OF THE MATERIAL

1. Consumption

In earlier chapters, consumption is described as a function solely of current disposable income. In fact,

however, people plan over longer horizons and are willing to borrow to finance current consumption

when current disposable income is temporarily low. As a benchmark, assume that a person wants a

constant flow of consumption over her lifetime. In this case, a perfectly rational person would develop a

consumption plan in two steps. First, she would calculate her total wealth—assets on hand (financial and

housing wealth) plus the present value of future labor income (so-called human wealth). Then, she would

calculate the proportion of this wealth that should be spent each year to maintain a constant consumption

level over her lifetime. If it happened that this level of consumption fell short of current income, the

difference would be borrowed.

In practice, most consumers following such a plan would end up borrowing large sums of money early in

life, because income during college and early working years is likely to be very low relative to income

later in life. In fact, however, most young adults do not borrow the relatively large sums suggested by

simple calculations, for several reasons. First, they may not intend to maintain constant consumption over

their lifetimes. Some expensive leisure activities will be deferred, and plans will be made for higher

expenditures while raising a family. Second, the computations involved in planning for constant

consumption may be too complicated. Life is simpler when decisions are based on rules of thumb. Third,

human wealth is based on forecasts of future earnings, which may turn out to be less than expected.

Consumers may wish to protect against this possibility by borrowing smaller amounts than would be

implied by expected present value calculations. Fourth, banks may be unwilling to extend much credit to

young adults on the expectation of future earnings.

This discussion suggests that consumption is likely to depend on two factors: wealth—because consumers

are to some degree forward looking—and current disposable income—because consumers may be

unwilling or unable to calculate and implement a spending plan expected to maintain constant

consumption over their lifetimes. Evidence on retirement saving suggests that most consumers save

sufficient resources for retirement. This finding lends support to the importance of wealth (and therefore

expectations) in consumption behavior. On the other hand, a substantial fraction of households (about

20% in some studies) do not save enough for retirement. For many of these households, the present value

of Social Security benefits accounts for almost all of their retirement wealth.

The fact that consumption depends upon wealth (which in turn depends upon expectations about the

future) has two empirical implications. First, fluctuations in current income are likely to generate less

than proportional fluctuations in consumption. Unless a fluctuation in current income is permanent,

human wealth (the expected present value of future labor income) will change less than proportionally,

which implies that consumption will probably change less than proportionally as well. Second,

consumption can be affected by changing expectations about the future, even when current income does

not change. A fall in consumer confidence helped create a recession in the United States in 1990-1991. A

decade later, macroeconomists were concerned that consumer confidence would fall dramatically after the

events of September 11 and prolong the recession. In the event, however, although there was some fall in

confidence in the latter part of 2001, the drop was smaller than in 1990-1991, and the economy soon

began to recover. However, the most recent recession following the financial crisis of 2007-2008 is

particularly striking when looking at consumer expectations regarding changes in family income. See

Figure 15-1 on page 318 to view the differences in magnitude of expectations.

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2. Investment

When deciding whether to purchase a new machine or to build a new plant, firms compare the expected

present value of profit from the machine or plant to the cost. If the present value of profit exceeds the

cost, they invest; if not, they do not invest. The calculation of the expected present value of profits

requires not only a forecast of profit, but also a consideration of the wear and tear on the machine or plant

from use. Wear and tear is called depreciation.

James Tobin pointed out that firms could use information available in financial markets to simplify the

investment decision. The financial value of a firm (its stock market value plus the value of bonds

outstanding) measures the value financial investors place on capital (plant and equipment) already in

place. Firms should invest when the financial value of a unit of their capital exceeds the cost of an

additional unit of capital. If firms behave in this way, there should be a positive relationship between

aggregate investment and the ratio of the total financial value of firms to the replacement cost of their

capital. The latter ratio is called Tobin’s “q.” In fact, there is a strong relationship between aggregate

investment and a one-year lag of the q variable. This relationship does not imply that firms use the stock

market to guide their investment behavior. However, theory suggests that stock prices and investment

decisions should be influenced by similar factors.

A convenient special case of the investment decision is described by the following scenario: the real

interest rate is constant, a new machine begins producing a constant annual (real) profit stream in one

year, and a new machine begins to depreciate at a constant rate in two years. In this case, in real terms,

the present value of expected profit, denoted by V(et), is given by

V(et)=t/(rt + ), (15.5)

where r is the real interest rate and  is the depreciation rate. The quantity r +  is called the user cost or

the rental cost of capital, since it represents the cost of renting a machine. The owner of a rented machine

would require the same real return available on alternative assets—i.e., the real interest rate—plus

compensation for depreciation.

Theory implies that investment should depend upon expected future profit, but there is also evidence that

investment increases when current profit increases, even after controlling for expected future profit.

Presumably, the effect of current profit is to reduce the amount of borrowing a firm must undertake to

invest. Firms may be reluctant to borrow, since they may be unable to repay their debt if the future turns

out worse than expected. Firms may also be unable to borrow, since lenders may not share the firm’s

optimistic assessment of its investment project. If a firm has high profit, it can retain some of its earnings

for investment, eliminating the need to take on debt or find enthusiastic lenders.

Investment depends on current and expected future profit, but what determines profit? The level of profit

per unit of capital is likely to be closely related to the level of sales per unit of capital. Ignoring the

distinction between sales and output, sales per unit of capital can be proxied by output per unit of capital.

In fact, there is a close relationship between changes in profit per unit of capital and changes in the

output-capital ratio.

3. The Volatility of Consumption and Investment

Although the consumption and investment decisions have some similarities, the theory developed above

suggests that investment should be much more volatile than consumption. After an increase in income

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perceived as permanent, consumers respond with at most an equal increase in consumption. After an

increase in sales perceived as permanent, however, firms may respond by investing in projects many

times larger than the increase in sales. In the absence of adjustment costs, firms have no reason to

maintain a smooth flow of investment. Once projects become profitable, firms invest immediately.

Consumers, on the other hand, desire to maintain a relatively constant level of consumption. In response

to a permanent increase in income, it makes no sense for them to borrow to try to consume the entire

future increase today.

In fact, although investment and consumption tend to move in the same direction, the movements of

investment are much higher in percentage terms. In absolute terms, however, movements of investment

and consumption are similar in magnitude, since total consumption is much larger than total investment.

V. PEDAGOGY

1. Points of Clarification

Instructors may wish to point out that what matters for investment is marginal—as opposed to average—

profit. When evaluating an investment possibility, firms care about the expected extra profit that can be

derived from employing one more unit of capital (marginal profit), rather than the expected profit per unit

of existing capital (average profit). Marginal and average profit can differ.

2. ALTERNATIVE SEQUENCING

Ricardian equivalence is discussed in Chapter 22, which is devoted to fiscal policy. Instructors could

easily introduce Ricardian equivalence in this chapter, as well.

VI. EXTENSIONS

1. The Evolution of Consumption Theory

The text presents modern consumption theory, but does not describe how the Keynesian consumption

function (KCF) came to be replaced by permanent income and life cycle theories. The story helps

illustrate the differences between the KCF and the consumption theory described in this chapter.

The Keynesian consumption function (KCF) implies that the ratio of consumption to income (or the

average propensity to consume (APC)) falls as income increases. Cross-section and time-series evidence

assembled after the publication of the General Theory bore out these claims. Based on the KCF and the

existing evidence, economists predicted during World War II that the economy could not sustain growth

after the war without high levels of government spending. Since the consumption-output ratio would fall

with income, some other component of output—in particular, government spending—would have to

increase to support growth. To the surprise of many economists, the economy did not stagnate after the

war, despite the associated fall in government spending. In addition, after the war, Simon Kuznets

collected longer-run data that showed no tendency for the APC to decline secularly.

The theories of Friedman and Modigliani explained the apparent puzzle between the prewar and postwar

evidence. The basic insight becomes clear in a simple example. Suppose that each year half of the

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population receives an income of $25,000 and the other half receives an income of $75,000. Those who

receive $25,000 know they will receive $75,000 in the following year, and those who receive $75,000

know they will receive $25,000 in the following year. Everyone desires to smooth consumption

completely, so everyone consumes $50,000 per year. In aggregate, the relationship between income and

consumption is stable and unchanging. In cross section, it will appear that the ratio of consumption to

income falls when income increases. Although there is no uncertainty in this example, the basic point is

clear. The cross-section evidence largely reflects transitory changes in income, which have little effect on

consumption. The aggregate evidence largely reflects the relationship between permanent income and

consumption. In the long run, aggregate income is driven primarily by permanent changes in income,

which tend to have close to proportional effects on consumption. So, in the long run, there is no tendency

for the APC to decline.

2. Consumption and Real Interest Rates

The text does not discuss the effect of the real interest rate on consumption. An increase in the current

period real interest rate has three effects: a substitution effect, an income effect, and a wealth effect. The

substitution effect describes a consumer’s response to the change in the price of future consumption in

terms of present consumption, i.e., 1/(1+r). An increase in the real interest rate reduces the relative price

of future consumption and tends to shift consumption from the present to the future.

This substitution effect tends to reduce current consumption. Intuitively, an increase in the real return on

bonds tends to make saving more attractive. The income effect describes the consumer’s response to the

change in interest income on existing saving. An increase in the real interest rate increases interest

income. The income effect tends to increase current consumption. Intuitively, a higher interest rate

means that any given level of future wealth can be achieved with less saving today, so consumption tends

to rise. Finally, the wealth effect describes the consumer’s response to the change in wealth caused by a

change in the real interest rate. An increase in the current interest rate tends to reduce human wealth (the

present value of expected after-tax labor income). This effect is larger to the extent that an increase in the

current rate also implies an increase in future interest rates. The wealth effect tends to reduce current

consumption.

In sum, the theoretical effects are contradictory. The substitution and wealth effects predict that

consumption responds negatively to the real interest rate, but the income effect predicts that consumption

responds positively to the real interest rate. Empirical studies typically do not find a strong relationship

between consumption and the real interest rate.

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