C H AP TE R

16
Expectations,
Consumption,
and Investment
Prepared by:
Fernando Quijano and Yvonn Quijano

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

16-1

Consumption

The theory of consumption was

developed by Milton Friedman
in the 1950s, who called it the
permanent income theory of
consumption, and by Franco
Modigliani, who called it the life
cycle theory of consumption.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Very Foresighted Consumer

A very foresighted consumer who decide how
much to consume based on the value of his
total wealth, which comprises:
The value of his nonhuman wealth, or the sum of

financial wealth and housing wealth.

The value of his human wealth, or the present
value of expected after-tax labor income.

2003 Prentice Hall Business Publishing

C ( to ta l w e a lth t )

Macroeconomics, 3/e

Olivier Blanchard

Toward a More Realistic Description

The constant level of consumption that a
consumer can afford equals his total wealth
divided by his expected remaining life.
Consumption depends not only on total wealth
but also on current income.
C t C ( to ta l w e a lth t ,Y LT T t )
Y

Lt

real labor income in year t.

T t real taxes in year t.

Y L T T t human wealth, or the expected present
value of after-tax labor income

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Toward a More Realistic Description

Evidence on the relative importance of wealth
and current income in consumption decisions
shows that both affect consumption.
This evidence is gathered through natural
experimentsexperiments that economists
cannot control, but occur naturally.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Putting Things Together: Current Income,

Expectations, and Consumption
Expectations affect consumption in two ways:
Directly through human wealth, or expectations of

future labor income, real interest rates, and taxes.

Indirectly through nonhuman wealthstocks,
bonds, and housing. Expectations of the value of
nonhuman wealth is computed by financial
markets.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Putting Things Together: Current Income,

Expectations, and Consumption
Consumption is likely to respond less than one
for one to fluctuations in current income.
Consumption may decrease one for one with a

decrease in income only if the decrease in income is

considered to be permanent.
Temporary changes in current income, such as those
caused by recessions and expansions, are unlikely to
increase consumption by as much as income.

Consumption may move even if current income

does not due to changes in consumer
confidence.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

16-2

Investment

Investment decisions depend on current sales,

the current real interest rate, and on
expectations of the future.
The decision to buy a machine depends on the
present value of the profits the firm can expect
from having this machine versus the cost of
buying it.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and Expectations of Profit

Depreciation:
The rate of depreciation, , measures how
much usefulness the machine loses from one
year to the next.
Reasonable values for are between 4 and
15% for machines, and between 2 and 4% for
buildings and factories.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and Expectations of Profit

The Present Value of Expected Profits, V( et):
The present value, in year t, of expected profit
in year t+1 equals:
1
e t1
1 rt
1
e
In year t+2,
(
1

t2
e
(1 rt ) (1 r t1 )
In year t,

1
V ( t)

1 rt
e

2003 Prentice Hall Business Publishing

t1

1
(1 rt )(1 r

t1

Macroeconomics, 3/e

(1 )

t2

Olivier Blanchard

Investment and Expectations of Profit

Computing the Present
Value of Expected
Profits

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Investment Decision

Denote It as aggregate investment, t as profit
per machine (or per unit of capital) for the
economy as a whole, and V(et) as the
expected present value of profit per unit of
capital. This yields the investment function:
I t I (V ( e t ) )
( )
In words, investment depends positively on the expected
present value of future profits (per unit of capital).

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and the Stock Market

James Tobin argued that there should be a
tight relation between the stock market and
investment.
The stock price tells firms how much the stock
market values each unit of capital already in
place; thus, the willingness to pay for one
more unit. If the stock market value exceeds
the purchase price, the firm should buy the
machine.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and the Stock Market

The stock market value of U.S. corporations
(share price times number of shares) divided
by the value of the capital stock of U.S.
corporations is called Tobins q.
This ratio gives the value of a unit of capital
relative to its current purchase price. The
higher the value of capital relative to its
current purchase price, the higher should be
investment.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and Expectations of Profit

Tobins q Versus the
Ratio of Investment to
CapitalAnnual Rates
of Change, 1960-1999
There is a tight relation
between investment and
the value of the stock
market.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

A Convenient Special Case

Assume that:
Future profits and future interest rates remain the

same as today, and

People have static expectations (expect the
future to be like the present).

Under these assumptions, the equation

1
V ( t)

1 rt
e

t1

becomes:

(
2003 Prentice Hall Business Publishing

1
(1 rt )(1 r
e

t )

t1

(1 )

t2

rt
Macroeconomics, 3/e

Olivier Blanchard

A Convenient Special Case

Given (

t )

rt

I t I (V (

and

It I

))

then,

rt

Investment is a function of the ratio of the

profit per unit of capital to the sum of the real
interest rate and the depreciation rate.
The term r t is called the user cost or the
rental cost of capital.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Current Versus Expected Profit

Investment depends on expected future profit,
but also moves strongly with fluctuations in
current profit.
I t I (V ( e t ) , t )
( , + )
Firms may be reluctant to borrow if current profit is

low. But if current profit is high, the firm may not

need to borrow to finance its investments. It does
not need to convince potential lenders.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Investment and Expectations of Profit

Changes in
Investment and
Changes in Profit in
the United States,
1960-2000
Investment and
profit move very
much together.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Profitability Versus Cash Flow

Profitability refers to the expected present
discounted value of profits.
Cash flow refers to current profit, or the net
flow of cash the firm is receiving.
Both profitability and cash flow are important
for investment decisions, and are likely to
move together.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Profits and Sales

Changes in Profit and
Changes in the Ratio
of Output to Capital in
the United States,
1960-2000
Profit and the ratio of
output to capital
move largely
together.

Yt

K t

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Volatility of
Consumption and Investment

16-3

Investment is more volatile than consumption.

Consumers do not increase consumption more
than one for one with increases in income.
Investment, on the other hand, may exceed an
increase in current sales.
Consumption and investment usually move
together. Both components contribute roughly
equally to fluctuations in output over time.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Volatility of
Consumption and Investment
Rates of Change of
Consumption and
Investment, 19602000
Relative movements
in investment are
much larger than
relative movements
in consumption.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Key Terms
permanent income theory of con
sumption,
life cycle theory of consumption,
financial wealth,
housing wealth,
human wealth,
nonhuman wealth,

2003 Prentice Hall Business Publishing

total wealth,
natural experiment,
Tobins q,
static expectations,
user cost of capital, or rental c
ost of capital,
profitability,
cash flow,

Macroeconomics, 3/e

Olivier Blanchard