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Household and Firm Behavior in the Macroeconomy: A Further Look. Households: Consumption and Labor Supply Decisions. Keynes suggested that consumption is a positive function of income, and that high-income households consume a smaller portion of their income than low-income households.

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Household and Firm Behavior in the Macroeconomy: A Further Look

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Household and firm behavior in the macroeconomy a further look

Household and Firm Behavior in the Macroeconomy:A Further Look


Households consumption and labor supply decisions

Households: Consumption andLabor Supply Decisions

  • Keynes suggested that consumption is a positive function of income, and that high-income households consume a smaller portion of their income than low-income households.


The keynesian theory of consumption a review

The Keynesian Theory of Consumption: A Review

  • The average propensity to consume (APC) is the proportion of income households spend on consumption. Determined by dividing consumption (C) by income (Y).


The life cycle theory of consumption

The Life-Cycle Theory of Consumption

  • The life-cycle theory of consumption is an extension of Keynes's theory. It states that households make lifetime consumption decisions based on their expectations of lifetime income.


The life cycle theory of consumption1

The Life-Cycle Theory of Consumption

  • People tend to consume less than they earn during their main working years, and dissave, or use up savings, during their early and later years.


The life cycle theory of consumption2

The Life-Cycle Theory of Consumption

  • Consumption decisions are likely to be based on permanent income rather than on current income.

  • Permanent income is the average level of one’s expected future income stream.


The life cycle theory of consumption3

The Life-Cycle Theory of Consumption

  • Policy changes, like tax-rate changes, are likely to have more of an effect on household behavior if they are expected to be permanent rather than temporary.


The labor supply decision

The Labor Supply Decision

  • Households make consumption and labor supply decisions simultaneously.

  • Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your consumption.


The labor supply decision1

The Labor Supply Decision

  • Factors that determine the quantity of labor supplied include:

    • The wage rate

    • Prices

    • Wealth and nonlabor income


The labor supply decision2

The Labor Supply Decision

  • An increase in the wage rate causes the opportunity cost of leisure to rise, leading to a larger labor supply—a larger labor force. This is called the substitution effect of a wage rate increase.


The labor supply decision3

The Labor Supply Decision

  • A higher wage means that people will spend some of it on leisure by working less. This is the income effect of a wage rate increase.

  • Data suggests that the substitution effect prevails over the income effect, so higher wages lead to an increase in labor supply.


The labor supply decision4

The Labor Supply Decision

  • Prices also play a major role in the consumption/labor supply decision.

  • The nominal wage rate is the wage rate in current dollars.

  • The real wage rate is the amount that the nominal wage rate can buy in terms of goods and services.


The labor supply decision5

The Labor Supply Decision

  • Workers do not care about their nominal wage—they care about the purchasing power of this wage—the real wage rate.


The labor supply decision6

The Labor Supply Decision

  • Wealth fluctuates over the life cycle.

  • 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.


The labor supply decision7

The Labor Supply Decision

  • An increase in wealth can be looked on as an increase in nonlabor income.

  • Nonlabor, or nonwage, income is income received from sources other than working – inheritances, interest, dividends, and transfer payments, and so on.


The labor supply decision8

The Labor Supply Decision

  • 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.


Interest rate effects on consumption

Interest Rate Effects on Consumption

  • A rise in the interest rate increases the reward to saving and lowers consumption. This is the substitution effect of an interest rate change.

  • There is also an income effect of an interest rate change. A fall in the interest rate leads to a fall in nonlabor income and consumption.


Interest rate effects on consumption1

Interest Rate Effects on Consumption

  • For households with positive wealth, the income effect of an interest rate change works in the opposite direction from the substitution effect.

  • When a household is a debtor, a fall in the interest rate means a fall in interest payments, so the income and substitution effects work in the same direction.


Government effects on consumption and labor supply taxes and transfers

Government Effects on Consumptionand Labor Supply: Taxes and Transfers

  • The government influences household behavior mainly through income tax rates and transfer payments.

  • Transfer payments are payments such as Social Security benefits, veterans benefits, and welfare benefits.


Government effects on consumption and labor supply taxes and transfers1

Government Effects on Consumptionand Labor Supply: Taxes and Transfers


A possible employment constraint on households

A Possible EmploymentConstraint on Households

  • The budget constraint, which separates those bundles of goods that are available to a household from those that are not, is determined by income, wealth, and prices.

  • Households consume less if they are constrained from working.


A possible employment constraint on households1

A Possible EmploymentConstraint on Households

  • The amount that a household would like to work within a given period at the current wage rate if it could find the work is called the unconstrained supply of labor.


A possible employment constraint on households2

A Possible EmploymentConstraint on Households

  • The amount that a household actually works in a given period at the current wage rate is the constrained supply of labor.

  • A household’s constrained supply of labor is not a variable over which it has any control.


Keynesian theory revisited

Keynesian Theory Revisited

  • It is incorrect to think consumption depends only on income, at least when there is full employment.

  • But if there is unemployment, the level of income depends exclusively on the employment decisions made by firms.


Keynesian theory revisited1

Keynesian Theory Revisited

  • To the extent that Keynes emphasized the relationship between consumption and income, Keynesian theory is considered to pertain to periods of unemployment.


A summary of household behavior

A Summary of Household Behavior

  • Factors that affect household consumption and labor supply decisions include:

    • Current and expected future real wage rates

    • Initial value of wealth

    • Current and expected future nonlabor income

    • Interest rates

    • Current and expected future tax rates and transfer payments


Consumption expenditures 1970 i 2003 ii

Consumption Expenditures,1970 I – 2003 II


Housing investment of the household sector 1970 i 2003 ii

Housing Investment of theHousehold Sector, 1970 I – 2003 II


C h a p t e r

Labor-Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I – 2003 II


Firms investment and employment decisions

Firms: Investment andEmployment Decisions

  • Inputs are the goods and services that firms purchase and turn into output.


Investment decisions

Investment Decisions

  • There are two ways that a firm can add to its capital stock:

    • Plant-and-equipment investment refers to purchases by firms of additional machines, factories, or buildings within a given period.

    • Inventory investment occurs when a firm produces more output than it sells within a given period.


Employment decisions

Employment Decisions

  • If the demand for labor increases at a time of less-than-full employment, the unemployment rate will fall.

  • If the demand for labor increases when there is full employment, wage rates will rise.


Employment decisions1

Employment Decisions

  • The demand for new capital, or planned investment spending, which is partly determined by the interest rate, is as important as the demand for labor.


Decision making and profit maximization

Decision Makingand Profit Maximization

  • A profit-maximizing firm chooses the technology that is most efficient—the one that minimizes the cost of production.

  • The most efficient technology depends on the relative prices of capital and labor.


Decision making and profit maximization1

Decision Makingand Profit Maximization

  • A labor-intensive technology is a production technique that uses a large amount of labor relative to capital.

  • A capital-intensive technology is a production technique that uses a large amount of capital relative to labor.


Decision making and profit maximization2

Decision Makingand Profit Maximization

  • Firms’ decisions about labor demand and investment are likely to depend on the relative costs of labor and capital.

  • The relative impact of an expansion of output on employment and on investment demand depends on the wage rate and the cost of capital.


Expectations and animal spirits

Expectations and Animal Spirits

  • Investment decisions require looking into the future and forming expectations about it.

  • Expectations are always formed with imperfect information.


Expectations and animal spirits1

Expectations and Animal Spirits

  • Keynes concludes that much investment activity depends on psychology and on what he calls the animal spirits of entrepreneurs (a phrase that describes investors’ feelings), which help to make investment a volatile component of GDP.


The accelerator effect

The Accelerator Effect

  • The accelerator effect is the tendency for investment to increase when aggregate output increases and decrease when aggregate output decreases, accelerating the growth or decline of output.


The accelerator effect1

The Accelerator Effect

  • If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low, further accelerating the growth of output.


Excess labor and excess capital effects

Excess Labor andExcess Capital Effects

  • Excess labor and/or excess capital are labor and capital that are not needed to produce the firm’s current level of output.

  • Decreasing its workforce and capital stock quickly can be costly for a firm.


Excess labor and excess capital effects1

Excess Labor andExcess Capital Effects

  • Adjustment costs are 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.


Inventory investment

Inventory Investment

  • Inventories are counted as part of a firm’s capital stock.


Inventory investment1

Inventory Investment

  • The desired, or optimal, level of inventories is 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).


Inventory investment2

Inventory Investment

  • There is a trade-off between holding inventories and changing production levels.

  • A firm’s production should fluctuate less than its sales, with changes in inventories absorbing the difference each period.


Inventory investment3

Inventory Investment

  • An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production.


Inventory investment4

Inventory Investment

  • A firm’s planned production path depends on the level of its expected future sales.

  • Future sales expectations are likely to have an important effect on current production.


A summary of firm behavior

A Summary of Firm Behavior

  • The following factors affect firms’ investment and employment decisions:

    • The wage rate and the cost of capital.

    • Firms’ expectations of future output.

    • The amount of excess labor and excess capital on hand.


A summary of firm behavior1

A Summary of Firm Behavior

  • The most important points to remember about the relationship between production, sales, and inventory investment are:

    • Inventory investment (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.

    • Current production depends on expected future sales.


Plant and equipment investment of the firm sector 1970 i 2003 ii

Plant and Equipment Investmentof the Firm Sector, 1970 I – 2003 II


Employment in the firm sector 1970 i 2003 ii

Employment in the Firm Sector,1970 I – 2003 II


Inventory investment of the firm sector and the inventory sales ratio 1970 i 2003 ii

Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I – 2003 II


Productivity and the business cycle

Productivity and the Business Cycle

  • Productivity, or labor productivity, is defined as output per worker hour (Y/H); the amount of output produced by an average worker in 1 hour.


Productivity and the business cycle1

Productivity and the Business Cycle

  • Productivity tends to rise during expansions and fall during contractions.

  • During expansions, output rises by a larger percentage than employment, and the ratio of output to workers rises.


Employment and output over the business cycle

Employment and Outputover the Business Cycle

  • In general, employment does not fluctuate as much as output over the business cycle.

  • As a result, measured productivity tends to rise during expansions and decline during contractions.


Productivity in the long run

Productivity in the Long Run

  • Theories of (long-run) economic growth focus on productivity, as measured by output per worker, or GDP per capita.

  • Using productivity figures to diagnose the economy in the short run can be misleading.


Productivity in the long run1

Productivity in the Long Run

  • The tendency of firms to hold excess labor and capital, and its implications for the measurement of productivity throughout the business cycle, has nothing to do with the economy’s long-run potential to produce output.


The relationship between output and unemployment

The Relationship BetweenOutput and Unemployment

  • Okun’s Law is a theory put forth by Arthur Okun, that the unemployment rate decreases about one 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 relationship between output and unemployment1

The Relationship BetweenOutput and Unemployment

  • Three “slippages” that make the change in the unemployment rate less than the percentage change in output in the short run:

    1.When output rises by 1 percent, the number of jobs does not tend to rise by 1 percent also.

    2.Some of the jobs are filled by people who already have one job.

    3.The response of the labor force to an increase in output.


The relationship between output and unemployment2

The Relationship BetweenOutput and Unemployment

  • The discouraged-worker effect is the decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking for jobs, dropping out of the ranks of the unemployed and the labor force.


The size of the multiplier

The Size of the Multiplier

  • Factors that lower the multiplier of government spending include:

    • Automatic stabilizers

    • Interest rate

    • Price level

    • Excess capital and excess labor

    • Inventories

    • Life-cycle story and expectations


The size of the multiplier1

The Size of the Multiplier

  • In practice, the multiplier probably has a value of around 1.4, at its peak. For example, if government spending rises by $1 billion, then GDP rises by about $1.4 billion.


The size of the multiplier2

The Size of the Multiplier

  • The response of the economy to a change in monetary or fiscal policy is not likely to be large and quick and, in the final analysis, the effects are much smaller than the simple multiplier would lead one to believe.


Review terms and concepts

Review Terms and Concepts

accelerator effect

adjustment costs

animal spirits of entrepreneurs

average propensity to consume (APC)

capital-intensive technology

constrained supply of labor

desired, or optimal, level of inventories

discouraged-worker effect

excess capital

excess labor

income effect of a wage rate increase

inputs

inventory investment

labor-intensive technology

life-cycle theory of consumption

nominal wage rate

nonlabor, or nonwage, income

Okun’s Law

permanent income

plant-and-equipment investment

productivity, or labor productivity

real wage rate

substitution effect of a wage rate increase

unconstrained supply of labor


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