Prepared by: Fernando Quijano & Shelly Tefft

1. P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N CASE FAIR OSTER Prepared by: Fernando Quijano & Shelly Tefft

3. Household and Firm Behavior in the Macroeconomy: A Further Look* 16 CHAPTER OUTLINE Households: Consumption and Labor Supply Decisions The Life-Cycle Theory of Consumption The Labor Supply Decision Interest Rate Effects on Consumption Government Effects on Consumption and Labor Supply: Taxes and Transfers 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!

4. Households: Consumption and Labor Supply Decisions The Life-Cycle Theory of Consumption life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their expectations of lifetime income. permanent income The average level of a person’s expected future income stream.

5. Households: Consumption and Labor Supply Decisions The Life-Cycle Theory of Consumption  FIGURE 16.1Life-Cycle Theory of Consumption In their early working years, people consume more than they earn. This is also true in the retirement years. In between, people save (consume less than they earn) to pay off debts from borrowing and to accumulate savings for retirement.

6. 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.

7. 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.

8. Households: Consumption and Labor Supply Decisions The Labor Supply Decision Demographics and both legal and illegal immigration play a role in determining the size of the labor force. Behavior also plays a role. 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 Wage Rate 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.

9. 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. c. Higher wages may or may not increase labor supply. d. There is no relationship between wages and labor supply.

10. 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. c. Higher wages may or may not increase labor supply. d. There is no relationship between wages and labor supply.

11. Households: Consumption and Labor Supply Decisions The Labor Supply Decision Prices 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.

12. Households: Consumption and Labor Supply Decisions The Labor Supply Decision 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. 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.

13. All else the same, an unexpected increase in wealth or nonlabor income causes: a. An increase in labor supply, an increase in present consumption, and a decrease in future consumption. b. A decrease in labor supply, a decrease in present consumption, and an increase in future consumption. c. A decrease in labor supply, and an increase in both present and future consumption. d. No change in labor supply, but higher present and future consumption.

14. All else the same, an unexpected increase in wealth or nonlabor income causes: a. An increase in labor supply, an increase in present consumption, and a decrease in future consumption. b. A decrease in labor supply, a decrease in present consumption, and an increase in future consumption. c. A decrease in labor supply, and an increase in both present and future consumption. d. No change in labor supply, but higher present and future consumption.

15. Households: Consumption and Labor Supply Decisions Interest Rate Effects on Consumption 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. Government Effects on Consumption and Labor Supply: Taxes and Transfers

16. If the substitution effect of a change in wages dominates, then an increase in income tax rates: 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. d. Lowers after-tax wages and lowers labor supply.

17. If the substitution effect of a change in wages dominates, then an increase in income tax rates: 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. d. Lowers after-tax wages and lowers labor supply.

18. Households: Consumption and Labor Supply Decisions A Possible Employment Constraint on Households 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.

19. Households: Consumption and Labor Supply Decisions A Possible Employment Constraint on Households Keynesian Theory Revisited Recall the Keynesian theory that current income determines current consumption. Although consumption and labor supply decisions depend on the real wage rate, if there is unemployment, income depends on the employment decisions made by firms and not on household decisions. Developed during a period of unemployment, Keynesian theory is considered to pertain to those periods.

20. Households: Consumption and Labor Supply Decisions A Summary of Household Behavior • The following factors affect household consumption and labor supply decisions: • 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

21. Households: Consumption and Labor Supply Decisions The Household Sector Since 1970  FIGURE 16.2Consumption Expenditures, 1970 I–2010 I Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable goods. Consumption

22. Which category of expenditures is “smoother” over time? a. Expenditures on services and nondurable goods. b. Expenditures on durable goods. c. Housing expenditures. d. All of the above categories of expenditures are very smooth over time.

23. Which category of expenditures is “smoother” over time? a. Expenditures on services and nondurable goods. b. Expenditures on durable goods. c. Housing expenditures. d. All of the above categories of expenditures are very smooth over time.

24. E C O N O M I C S I N P R A C T I C E Household Reactions to Winning the Lottery 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. Smith Prepares to Leave Office after Winning Lottery The Baltimore Sun

25. Households: Consumption and Labor Supply Decisions  FIGURE 16.3Housing Investment of the Household Sector, 1970 I–2010 I The Household Sector Since 1970 Housing investment fell during the five recessionary periods since 1970. Like expenditures for durable goods, expenditures for housing investment are postponable. Housing Investment

26. Households: Consumption and Labor Supply Decisions  FIGURE 16.4Labor 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 Since 1970, the labor force participation rate for prime-age men has been decreasing slightly. 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). Labor Supply

27. Firms: Investment and Employment Decisions Expectations and Animal Spirits animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings. The Accelerator Effect 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.

28. When Keynes referred to the animal spirits of entrepreneurs, he meant that: a. Investment decisions are always made with imperfect knowledge. b. Investment activity depends on psychology. c. Investment is based on expectations involving great uncertainty. d. All of the above.

29. When Keynes referred to the animal spirits of entrepreneurs, he meant that: a. Investment decisions are always made with imperfect knowledge. b. Investment activity depends on psychology. c. Investment is based on expectations involving great uncertainty. d. All of the above.

30. Firms: Investment and Employment Decisions Excess Labor and Excess Capital Effects 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.

31. Firms: Investment and Employment Decisions Inventory Investment inventory investment The change in the stock of inventories. The Role of Inventories Stock of inventories (end of period) = Stock of inventories (beginning of period) + Production − Sales The Optimal Inventory Policy 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).

32. If the costs of adjusting production levels are greater than the costs of maintaining inventories, a. A firm will immediately adjust production to match any increases or decreases in sales. 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.

33. If the costs of adjusting production levels are greater than the costs of maintaining inventories, a. A firm will immediately adjust production to match any increases or decreases in sales. 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.

34. Firms: Investment and Employment Decisions A Summary of Firm Behavior • 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 • 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. • Current production depends on expected future sales.

35. Firms: Investment and Employment Decisions  FIGURE 16.5Plant-and-Equipment Investment of the Firm Sector, 1970 I–2010 I The Firm Sector Since 1970 Overall, plant-and-equipment investment declined in the five recessionary periods since 1970. Plant-and-Equipment Investment

36. Firms: Investment and Employment Decisions  FIGURE 16.6Employment in the Firm Sector, 1970 I–2010 I The Firm Sector Since 1970 Growth in employment was generally negative in the five recessions the U.S. economy has experienced since 1970. Employment

37. Firms: Investment and Employment Decisions  FIGURE 16.7Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2010 I The Firm Sector Since 1970 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. Inventory Investment

38. Productivity and the Business Cycle productivity, or labor productivity Output per worker hour.  FIGURE 16.8Employment and Output over the Business Cycle In general, employment does not fluctuate as much as output over the business cycle. As a result, measured productivity (the output-to-labor ratio) tends to rise during expansionary periods and decline during contractionary periods.

39. The Short-Run Relationship Between Output and Unemployment 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. 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. 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.

40. The Size of the Multiplier • 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: • There are automatic stabilizers. • There is the interest rate. • There is the response of the price level. • There are excess capital and excess labor. • There are inventories. • There are people’s expectations about the future. The Size of the Multiplier in Practice In practice, the multiplier probably has a value of around 2.0. Its size also depends on how long ago the spending increase began.

41. R E V I E W T E R M S A N D C O N C E P T S accelerator effect adjustment costs animal spirits of entrepreneurs constrained supply of labor desired, or optimal, level of inventories discouraged-worker effect excess capital excess labor inventory investment life-cycle theory of consumption nominal wage rate nonlabor, or nonwage, income Okun’s Law permanent income productivity, or labor productivity real wage rate unconstrained supply of labor