The Keynesian Theory of Consumption: A Review

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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.. People tend to consume less than they earn during their main working years, and dissave during their early and later years..
The Keynesian Theory of Consumption: A Review

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1. The Keynesian Theory of Consumption: A Review 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 average propensity to consume is the portion of income households spend on consumption.

2. 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.

3. 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. 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 pioneering work on this topic was done by Milton Friedman.The pioneering work on this topic was done by Milton Friedman.

4. 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. Factors that determine the quantity of labor supplied include the wage rate, prices, wealth, and nonlabor income.

5. 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. On the other hand, 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.

6. The Labor Supply Decision Prices also play a major role in the 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. Workers do not care about their nominal wage?they care about the purchasing power of this wage?the real wage rate.

7. 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. 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.

8. 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.

9. 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. On the other hand, if 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. Data suggests that the substitution effect dominates over the income effect, so the net effect of a higher interest rate on consumption is negative. However, there is evidence that the income effect is getting larger over time.Data suggests that the substitution effect dominates over the income effect, so the net effect of a higher interest rate on consumption is negative. However, there is evidence that the income effect is getting larger over time.

10. Government Effects on Consumption and Labor Supply: Taxes and Transfers

11. A Possible Employment Constraint 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. When a household is constrained from working as much as it would like, it consumes less. The amount that a household would like to work at the current wage rate if it could find the work is called the unconstrained supply of labor. The amount of labor that a household supplies is imposed from the outside by the workings of the economy. However, the household?s consumption is under its control.The amount of labor that a household supplies is imposed from the outside by the workings of the economy. However, the household?s consumption is under its control.

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

13. A Summary of Household Behavior Factors that affect household consumption and labor supply decisions include: current and expected future real wage rates the initial value of wealth current and expected future nonlabor income interest rates current and expected future tax rates and transfer payments

14. Consumption Expenditures, 1970 I ? 2000 II Expenditures on services and nondurable goods are ?smoother? over time than expenditures on durable goods. The decrease in expenditures on services and nondurable goods is smaller during the three recessionary periods than the decrease in expenditures on durable goods.The decrease in expenditures on services and nondurable goods is smaller during the three recessionary periods than the decrease in expenditures on durable goods.

15. Housing Investment of the Household Sector, 1970 I ? 2000 II Housing investment is the most easily postponable of all household expenditures. It is also sensitive to interest rates, which fluctuate greatly over time.Housing investment is the most easily postponable of all household expenditures. It is also sensitive to interest rates, which fluctuate greatly over time.

16. Labor-Force Participation Rate for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I ? 2000 II The participation rate of prime-age women is still below the rate for prime-age men. The participation rate for all individuals 16 and over except prime-age men and women has some cyclical features which reveal the operation of the discouraged-worker effect (which is quite small for prime-age women and men). The participation rate for non-prime-age men and women has fallen since 1970. This may be due to an increase in early retirement.The participation rate of prime-age women is still below the rate for prime-age men. The participation rate for all individuals 16 and over except prime-age men and women has some cyclical features which reveal the operation of the discouraged-worker effect (which is quite small for prime-age women and men). The participation rate for non-prime-age men and women has fallen since 1970. This may be due to an increase in early retirement.

17. Firms: Investment and Employment Decisions Inputs are the goods and services that firms purchase and turn into output. There are two ways that firms can add to their stock of capital: 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.

18. 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. 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.

19. Employment Decisions The decision of how much output to produce requires a decision concerning the method of production, or technology. 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.

20. Employment Decisions 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. The relative impact of an expansion of output on employment and on investment demand depends on the wage rate and the cost of capital. When labor-intensive technologies are used, expansion is likely to increase the demand for labor substantially while increasing the demand for capital only modestly.When labor-intensive technologies are used, expansion is likely to increase the demand for labor substantially while increasing the demand for capital only modestly.

21. Expectations and Animal Spirits Investment decisions require looking into the future and forming expectations about it. Expectations are always made with imperfect information. Keynes concludes that much investment activity depends on psychology and on what he calls the animal spirits of entrepreneurs, which help to make investment a volatile component of GDP.

22. 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. 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.

23. Excess Labor and Excess Capital Effects Excess labor and 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. 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. The more excess capital a firm already has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future.The more excess capital a firm already has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future.

24. Inventory Investment Stock of inventories (end of period) = Stock of inventories (beginning of period) + Production ? Sales A firm aims to produce the volume of goods that make its stock of inventories at the end of the period equal to the desired stock.A firm aims to produce the volume of goods that make its stock of inventories at the end of the period equal to the desired stock.

25. Inventory Investment There is a trade-off between holding inventories and changing production levels. Because of adjustment costs, a firm is likely to smooth its production path relative to its sales path. Production should fluctuate less than sales, with changes in inventories absorbing the difference each period. A firm aims to produce the volume of goods that make its stock of inventories at the end of the period equal to the desired stock.A firm aims to produce the volume of goods that make its stock of inventories at the end of the period equal to the desired stock.

26. 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. A firm?s planned production path depends on the level of its expected future sales path. Future sales expectations are likely to have an important effect on current production. Keynes?s view that animal spirits affect investment is also likely to pertain to output.Keynes?s view that animal spirits affect investment is also likely to pertain to output.

27. 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. An important component of the cost of capital is the interest rate.An important component of the cost of capital is the interest rate.

28. A Summary of Firm Behavior The most important points to remember about the relationship between 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. current production depends on expected future sales. An important component of the cost of capital is the interest rate.An important component of the cost of capital is the interest rate.

29. Plant and Equipment Investment of the Firm Sector, 1970 I ? 2000 II Plant and equipment investment generally does poorly when GDP does poorly and investment generally does well when GDP does well. Investment fluctuates greatly. Housing investment fluctuates more than plant and equipment investment. Plant and equipment investment generally does poorly when GDP does poorly and investment generally does well when GDP does well. Investment fluctuates greatly. Housing investment fluctuates more than plant and equipment investment.

30. Employment in the Firm Sector, 1970 I ? 2000 II Employment fell in the three recessionary periods. This is consistent with the theory that employment depends in part on output.Employment fell in the three recessionary periods. This is consistent with the theory that employment depends in part on output.

31. Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I ? 2000 II The inventory/sales ratio is the ratio of the firm sector?s stock of inventories to the level of sales. Inventory investment is very volatile.The inventory/sales ratio is the ratio of the firm sector?s stock of inventories to the level of sales. Inventory investment is very volatile.

32. 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 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. During downswings, output falls faster than employment and the ratio of output to workers falls.During downswings, output falls faster than employment and the ratio of output to workers falls.

33. Employment and Output over the Business Cycle In general, employment does not fluctuate as much as output over the business cycle. During downswings, output falls faster than employment and the ratio of output to workers falls.During downswings, output falls faster than employment and the ratio of output to workers falls.

34. 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. 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.

35. The Relationship Between Output 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. It is true, however, that a 1 percent increase in output tends to correspond to a less than 1 percentage point decrease in the unemployment rate.It is true, however, that a 1 percent increase in output tends to correspond to a less than 1 percentage point decrease in the unemployment rate.

36. The Relationship Between Output and Unemployment There are three ?slippages? that combine to make the change in the unemployment rate less than the percentage change in output in the short run: A firm is likely to meet some of the increase in output by increasing the number of hours worked per job. The number of hours (overtime) can increase, and excess labor can be back to work. Since some people hold more than one job, the increase in the number of people employed is less than the increase in the number of jobs. The size of the first slippage depends on how much excess labor is being held at the time of the output increase. The size of the third slippage depends on what else is affecting the labor force (like changes in real wages) at the time of the output increase.A firm is likely to meet some of the increase in output by increasing the number of hours worked per job. The number of hours (overtime) can increase, and excess labor can be back to work. Since some people hold more than one job, the increase in the number of people employed is less than the increase in the number of jobs. The size of the first slippage depends on how much excess labor is being held at the time of the output increase. The size of the third slippage depends on what else is affecting the labor force (like changes in real wages) at the time of the output increase.

37. The Size of the Multiplier There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example:

38. The Size of the Multiplier There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example: When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more.When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more.

39. The Size of the Multiplier There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example: When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more. The size of the multiplier is also smaller because spending ?leaks? into imports.When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more. The size of the multiplier is also smaller because spending ?leaks? into imports.

40. 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 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. When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more.When capital and labor are put back to work, consumption also increases less than it would have if employment (and thus household income) had increased more.


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