Macroeconomics: Case Fair Oster

PRINCIPLES OF
MACROECONOMICS
TENTH EDITION
PART IV Further Macroeconomics Issues
CASE FAIR OSTER

2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly
1 ofTefft
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2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 27

Household and Firm Behavior
in the Macroeconomy: 16
A Further Look* 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
* This chapter is somewhat more advanced,
but it contains a lot of interesting information! Productivity and the Business Cycle
The Short-Run Relationship Between
Output and Unemployment
The Size of the Multiplier
Households: Consumption and Labor Supply Decisions
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 persons

expected future income stream.

FIGURE 16.1
Life-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.

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

supplieda 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.

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.

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 workinginheritances, interest,
dividends, transfer payments, and so on.
An unexpected increase in nonlabor income will have a

positive effect on a households consumption.
An unexpected increase in wealth or nonlabor income leads

to a decrease in labor supply.

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

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.

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.

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.

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

The Household Sector Since 1970

FIGURE 16.2 Consumption Expenditures, 1970 I2010 I
Over time, expenditures on services and nondurable
Consumption goods are smoother than expenditures on durable goods.

EC ON OMIC S IN PRACTICE
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

FIGURE 16.3 Housing Investment of the Household
Sector, 1970 I2010 I
The Household Sector Since 1970 Housing investment fell during the five
recessionary periods since 1970.
Like expenditures for durable goods, expenditures
Housing Investment for housing investment are postponable.

FIGURE 16.4 Labor Force Participation Rates for Men 25 to 54, Women 25
to 54, and All Others 16 and Over, 1970 I2010 I
The Household Sector Since 1970, the labor force participation rate for prime-age men has been
Since 1970 decreasing slightly.
The rate for prime-age women has been increasing dramatically.
Labor Supply 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).

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.

Excess Labor and Excess Capital Effects
excess labor, excess capital Labor and capital that are

not needed to produce the firms current level of output.
adjustment costs The costs that a firm incurs when it

changes its production levelfor example, the
administration costs of laying off employees or the training
costs of hiring new workers.

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).
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 investmentthat is, the change in the stock of

inventoriesequals 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.

FIGURE 16.5 Plant-and-Equipment Investment of the
The Firm Sector Since 1970 Firm Sector, 1970 I2010 I
Overall, plant-and-equipment investment declined
in the five recessionary periods since 1970.
Plant-and-Equipment Investment

FIGURE 16.6 Employment in the Firm Sector, 1970 I2010 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

FIGURE 16.7 Inventory Investment of the Firm
The Firm Sector Since 1970 Sector and the Inventory/Sales Ratio, 1970 I2010 I
The inventory/sales ratio is the ratio of the firm
sectors stock of inventories to the level of sales.
Inventory Investment Inventory investment is very volatile.

Productivity and the Business Cycle
productivity, or labor productivity Output per worker hour.
FIGURE 16.8
Employment 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.
The Short-Run Relationship Between Output and Unemployment
Okuns 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 Okuns 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.

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:
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 peoples 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.
REVIEW TERMS AND CONCEPTS
accelerator effect life-cycle theory of consumption
adjustment costs nominal wage rate
animal spirits of entrepreneurs nonlabor, or nonwage, income
constrained supply of labor Okuns Law
desired, or optimal, level of inventories permanent income
discouraged-worker effect productivity, or labor productivity

excess capital real wage rate
excess labor unconstrained supply of labor
inventory investment

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PRINCIPLES OF

CASE FAIR OSTER

2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 27

The Life-Cycle Theory of Consumption

life-cycle theory of consumption A theory of household

permanent income The average level of a persons

2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 27

The Life-Cycle Theory of Consumption

2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 27

The Labor Supply Decision

Demographics and both legal and illegal immigration play a role in

Behavior also plays a role. Consumption cannot be considered

The Wage Rate

A higher wage would lead to a larger quantity of labor

If we assume that leisure is a normal good, people with

2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 27

The Labor Supply Decision

nominal wage rate The wage rate in current dollars.

real wage rate The amount the nominal wage rate

Households look at expected future real wage rates as well

2012 Pearson Education, Inc. Publishing as Prentice Hall 7 of 27

The Labor Supply Decision

Wealth and Nonlabor Income

Holding everything else constant (including the stage in the

nonlabor, or nonwage, income Any income received

dividends, transfer payments, and so on.

An unexpected increase in nonlabor income will have a

An unexpected increase in wealth or nonlabor income leads

2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 27

Interest Rate Effects on Consumption

There is also an income effect of an interest rate change on

Government Effects on Consumption and Labor Supply: Taxes and Transfers

Income Tax Rates Transfer Payments

Increase Decrease Increase Decrease

2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 27

A Possible Employment Constraint on Households

How does a household respond when it is constrained from working

unconstrained supply of labor The amount a

constrained supply of labor The amount a household

2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 27

A Possible Employment Constraint on Households

Keynesian Theory Revisited

Recall the Keynesian theory that current income determines

Although consumption and labor supply decisions depend on

Developed during a period of unemployment, Keynesian

2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 27

A Summary of Household Behavior

The following factors affect household consumption and labor supply

Current and expected future real wage rates

Initial value of wealth

Current and expected future nonlabor income

Current and expected future tax rates and transfer payments

2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 27

The Household Sector Since 1970

2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 27

Household Reactions to Winning the Lottery

The more nuanced theory of

A study by three economists,

Smith Prepares to Leave Office after Winning Lottery

2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 27

2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 27

2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 27

Expectations and Animal Spirits