Principles of macroeconomics 10e by case fair oster ch16

A Further Look* Households: Consumption and Labor A Possible Employment Constraint on Households A Summary of Household Behavior The Household Sector Since 1970 Firms: Investment and Emp

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T E N T H E D I T I O N

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A Further Look* Households: Consumption and Labor

A Possible Employment Constraint on Households

A Summary of Household Behavior The Household Sector Since 1970

Firms: Investment and Employment Decisions

Expectations and Animal Spirits Excess Labor and Excess Capital Effects Inventory Investment

A Summary of Firm Behavior The Firm Sector Since 1970

Productivity and the Business Cycle The Short-Run Relationship Between Output and Unemployment

The Size of the Multiplier

* This chapter is somewhat more advanced,

but it contains a lot of interesting information!

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life-cycle theory of consumption A theory of household

consumption: Households make lifetime consumption decisions based on their expectations of lifetime income

Households: Consumption and Labor Supply Decisions

The Life-Cycle Theory of Consumption

permanent income The average level of a person’s

expected future income stream

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than they earn)

to pay off debts

The Life-Cycle Theory of Consumption

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In the life-cycle theory of consumption,

a The more income you have, the more consuming you are likely to

do

b High-income households consume a smaller proportion of their

income than low-income households

c People tend to consume less than they earn during their main

working years

d All of the above

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In the life-cycle theory of consumption,

a The more income you have, the more consuming you are likely to

do

b High-income households consume a smaller proportion of their

income than low-income households

working years.

d All of the above

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A higher wage would lead to a larger quantity of labor

supplied—a larger workforce This is called the substitution

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 This is the income effect of a wage rate increase.

The Labor Supply Decision

The Wage Rate

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The data suggest that the substitution effect of a wage increase seems

to win over the income effect This means that:

a Higher wage rates usually lead to a larger labor supply

b Higher wage rates usually lead to a lower labor supply

d There is no relationship between wages and labor supply

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The data suggest that the substitution effect of a wage increase seems

to win over the income effect This means that:

b Higher wage rates usually lead to a lower labor supply

d There is no relationship between wages and labor supply

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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

Prices

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nonlabor, or nonwage, income Any income received

from sources other than working—inheritances, interest, dividends, transfer payments, and so on

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.

Wealth and Nonlabor Income

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

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present and future consumption.

d No change in labor supply, but higher present and future consumption

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A rise in the interest rate leads you to consume less today and save

more This effect is called the substitution effect.

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

Interest Rate Effects on Consumption

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.

Government Effects on Consumption and Labor Supply: Taxes and Transfers

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a Increases after-tax wages and increases labor supply.

b Increases after-tax wages and lowers labor supply

c Lowers after-tax wages and increases labor supply

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a Increases after-tax wages and increases labor supply.

b Increases after-tax wages and lowers labor supply

c Lowers after-tax wages and increases labor supply

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How does a household respond when it is constrained from working

as much as it would like?

It consumes less

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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Keynesian Theory Revisited

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Current and expected future tax rates and transfer payments

A Summary of Household Behavior

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 FIGURE 16.2 Consumption Expenditures, 1970 I–2010 I

The Household Sector Since 1970

Consumption

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Which category of expenditures is “smoother” over time?

a Expenditures on services and nondurable goods

b Expenditures on durable goods

d All of the above categories of expenditures are very smooth over

time

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Which category of expenditures is “smoother” over time?

b Expenditures on durable goods

d All of the above categories of expenditures are very smooth over

time

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The more nuanced theory of

consumption that we have

explored in this chapter makes

some predictions about what

households will do if they have a

sudden increase in wealth

Of course, such increases are

uncommon, but winning the

lottery is one such example

A study by three economists,

Guido Imbens, Donald Rubin, and Bruce Sacerdote, of a large sample of

lottery winners found that winning reduced work hours by 11 percent and that

of the first half of lottery winnings received, 16 percent on average was saved

Household Reactions to Winning the Lottery

E C O N O M I C S I N P R A C T I C E

Smith Prepares to Leave Office after Winning Lottery

The Baltimore Sun

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 FIGURE 16.3 Housing Investment of the Household Sector, 1970 I–2010 I

The Household Sector Since 1970

Housing Investment

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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–2010 I

The Household Sector

Since 1970

Labor Supply

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animal spirits of entrepreneurs A term coined

by Keynes to describe investors’ feelings

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

Firms: Investment and Employment Decisions

Expectations and Animal Spirits

The Accelerator Effect

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c Investment is based on expectations involving great uncertainty.

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c Investment is based on expectations involving great uncertainty.

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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

Excess Labor and Excess Capital Effects

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inventory investment The change in the stock of inventories.

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

+ Production − Sales

Inventory Investment

The Role of Inventories

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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b Output produced will tend to be less than output sold

c A firm may lower production by less than a decrease in sales, allowing inventories to rise

d Fluctuations in production will be greater than the corresponding fluctuations in sales

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b Output produced will tend to be less than output sold

sales, allowing inventories to rise.

d Fluctuations in production will be greater than the corresponding fluctuations in sales

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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

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

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Overall, plant-and-equipment investment declined

in the five recessionary periods since 1970

 FIGURE 16.5 Plant-and-Equipment Investment of the Firm Sector, 1970 I–2010 I

The Firm Sector Since 1970

Plant-and-Equipment Investment

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 FIGURE 16.6 Employment in the Firm Sector, 1970 I–2010 I

Employment

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Inventory investment is very volatile.

 FIGURE 16.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2010 I

Inventory Investment

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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

The Short-Run Relationship Between Output and Unemployment

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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We can finally bring together the material in this chapter and in previous

chapters to consider the size of the multiplier Earlier we mentioned that much of the analysis we would do after deriving the simple multiplier would have the

effect of decreasing the size of the multiplier

We can now summarize why:

1 There are automatic stabilizers.

2 There is the interest rate.

3 There is the response of the price level.

4 There are excess capital and excess labor.

5 There are inventories.

6 There are people’s expectations about the future.

In practice, the multiplier probably has a value of around 2.0

The Size of the Multiplier

The Size of the Multiplier in Practice

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animal spirits of entrepreneurs

constrained supply of labor

desired, or optimal, level of inventories

productivity, or labor productivity

real wage rateunconstrained supply of labor

R E V I E W T E R M S A N D C O N C E P T S

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