Transcript Goods Market

Business, Government, and the
World Economy
Consumption, Saving & Investment
Aggregate Demand
The amount that consumers, business and
Government wants to purchase.
Consumption
Investment
Government
IS/LM Model – joint determination of output and
interest rates
Consumption
Average or expected income of consumers
Cost and availability of credit
The Decision to save vs. spend
Determinants of Consumption
Disposable Income
Expected average Disposable Income
Changes in Tax Rates
Cost and Availability of Credit
Demographic factors
Expected Rate of Return on Investment Assets
Changes in spendable income from asset price
fluctuations (not part of DI)
Consumer Attitudes
Empirical Evidence
Consumption / Income is constant in long run
Short run changes in consumption are not as
closely correlated with income
Cons based on average or expected income
Attitudes shift frequently
Cost of credit changes quickly
Consumption is smoother in short run than
income except during recessions
Empirical Evidence
Changes in realized capital gains are not
reflected in disposable income, (similarly a
reduction in mortgage rates could increase
disposable income)
Declines in available credit can have a larger
influence on consumption than expected.
Variability of Consumption Spending
1990 recession – consumption spending
declined .2% over first 5 quarters
2001 recession – consumption spending
increased by more than 3% (income growth,
consumer sentiment both declined)
Post 2008 – increase in saving
Quarterly Variability
Changes in disposable income explains less
than half of change in consumer spending
Changes in money variables such as yield
spread, money supply, stock prices, consumer
credit also explain less than half (only 25%)
The remainder of the fluctuation is explained
by exogenous and random factors –
political shocks etc.
Long-term Variability
Over 60% of the one year change can be
explained by disposable income, costs,
availability of credit and asset prices
For a 3 year change over 90% of the of the
change can be explained by changes in
disposable income etc.
Managers need to be careful to not over
respond to short term shifts.
Quick Review
Linear Regression - Provides line the best
describes the relationship between two
variables
R2 - Portion of relationship explained by the
estimated line
T-Statistic - Confidence in the estimate of the
variable (Is is statistically significant?)
Standard Error - Confidence Interval
Quarter to Quarter Results
1959-I to 2012 -2
Y = % change in Real Personal Consumption Expenditure Quarter to Quarter
X= % change in Real Disposable Income Quarter to Quarter
Regression Statistics
Multiple R
0.459396353
R Square
0.21104501
Adjusted R Square
0.207305886
Standard Error
0.006234187
Observations
213
Intercept
DI
Coefficients Standard Error
0.005320664
0.000570322
0.353144119
0.04700557
t Stat
P-value
9.329219465 1.50822E-17
7.512814355 1.6173E-12
Yearly Changes
Y = % change in Real Personal Consumption Expenditure Year to Year
X= % change in Real Disposable Income Year to Year
Regression Statistics
Multiple R
0.751263837
R Square
0.564397353
Adjusted R Square
0.562303109
Standard Error
0.013313621
Observations
210
Intercept
DI
Coefficients
0.009081583
0.738413613
Standard Error
0.001729541
0.04498014
t Stat
P-value
5.250862 3.7292E-07
16.41644 2.1401E-39
Yearly % Change
3 year % Change
1962 - 2011
Y = 3 year % change in Real Personal Consumption Expenditure
X = 3 Year % change in Real Personal Disposable Income
Regression Statistics
Multiple R
0.898543
R Square
0.807379
Adjusted R Square
0.806416
Standard Error
0.020092
Observations
202
Intercept
DI
Coefficients
0.0053786
0.9638300
Standard Error
0.00370
0.03329
t Stat
1.45542
28.95360
P-value
0.14712
1.85E-73
3 year % change
The Consumption Function
Basic idea is trying to determine the
relationship between consumption and the
key inputs.
Start with a simple model
Assume that consumption is actually
determined by
Disposable income (DI)
Marginal propensity to consume (MPC)
C = a + (mpc)(DI)
Impact of Consumption
We said before that output in the economy
equals income.
C + G + I + NX
Assume no trade so output = C + G + I
Planned Expenditure
Substituting the consumption function into the
equation for C produces
a + (mpc)Y + G + I
Let this equal the amount of planned spending
in the economy.
mpc will generally be less than 1
Keynesian Cross
Graph Planned expenditure on vertical axis and
output (or income) on the horizontal.
Let Y* be the equilibrium level of spending where
planned spending equals output (income)
When output is less than Y*
Planned Spending > Output (income)
Inventories decline production increases
When output is greater than y*
Planned Spending < Output (Income)
inventories increase, production increases.
“Old” interpretation
Given that the data supports that low income
workers are dissaving and high income
workers are saving:
Can it be said that:
The personal saving rate increases as income
increases? (Keynes)
Total GDP can be increased by transferring wealth
Increases in income is accompanied by increases in
saving that is not fully invested – need to increase
G relative to everything else
Assuming Old Interpretation is Correct
The following outcomes which are not supported by
data would occur if the old interpretation is correct
Consumption would not rise as fast as income and
savings would increase over time (as real income as
increased)
Consumption would be a function of only income – not
financial variables such as interest rates and credit
The saving rate would decline in recession
Saving rates would be higher for “richer” individuals
PIH
Consumption is based on expected or
permanent income, not just current income.
Permanent Income Hypothesis
Those at the high end of the income scale
have income above their long term expected
income (permanent income) – therefore they
are saving (not because they have high
permanent income)
Those at the low end of the income scale
have income below their long term expected
income (permanent Income) – therefore they
borrow (not because they have low
permanent income).
PIH (two periods)
You can save a portion of your income. Let
labor income = Y then there is savings
available in year 2 equal to
(1+r)(Y1-C1)
The total amount available to spend in year 2 is
then
C2 = Y2+ (1+r)(Y1-C1)
C2 = Y2+ (1+r)(Y1-C1)
Rearrange
C2 (1+r)(C1) = Y2+ (1+r)(Y1)
Divide by 1+r
C1 + C2/(1+r) = Y1+Y2/(1+r)
The PV of consumption must equal the PV of
income -- in other words the key constraint
on consumption is your lifetime income.
Intertemporal Budget Constraint
Graph period 2 consumption on vertical axis
(max value = Y1(1+r) + Y2)
Graph period 1 consumption on horizontal axis
(Max value = Y1+Y2/(1+r))
Combine budget constraint with indifference
curves (combinations of consumption with
same utility)
An Increase in Income
Assume that future income (Y2) increases by
$50,000.
Assume that current income increases by
$50,000
In either case consumption increases in both
periods
Basic Perm Income model sets consumption
equal in both periods.
PIH and MPC
You still have the choice between saving and
consuming – the marginal propensity to
consume still plays a key role.
In both the Keynesian model and the
intertemporal model an increase in permenant
income will cause a large increase in current
consumption
Precautionary Saving
In reality future income is uncertain. The
choice to save or consume is then in part based
on precautionary saving (insurance against
future uncertainty)
This impacts the marginal propensity to
consume.
Credit
Given the intertemporal nature of the
consumption decision, the amount of credit
available and the cost of credit play key role in
the decision to save or consume.
Current Consumption Theory
Life Cycle Model of Saving and Consumption)
People will attempt to borrow and save to keep
the purchase of goods and services more stable
than income.
Everyone will act “rationally” to maximize their
own self interest by:
Interpreting and Weighing Information
Appropriately Balancing & Evaluating Choices
Making Informed Decisions
Life Cycle Model
Saving
Consumption
Borrowing
Dissaving
Income
Entrance to
Workforce
Retirement
Age
Implications of Life Cycle Model
Saving Decisions
Individuals understand the need to save for retirement
and can estimate the amount they need to save.
In other words consumers:
Understand the impact time has on the value of their
money.
Make informed decisions about their investment choices
and actively respond to changes in the economic
environment.
Act in a manner that maximizes their investment income.
Can accurately plan for a retirement age.
Life Cycle Implications
Individuals attempt to “smooth” consumption
If income drops due to short term layoff – the
expectation is that consumption would not
decrease as much as income.
If income drop is viewed as “permanent”
consumption may drop by the same amount as
income.
Extension
Individuals at the high end of income scale should have current income higher than their
long term expected income - they should save
Individuals at the low end of the income scale
– should have current income less than their
long term expected income – they should
dissave (borrow)
Some real world data
Is PIH correct?
Only 42% of workers have calculated how much
they need for retirement. (EBRI* 2006).
30% of US workers have not saved anything for
retirement (EBRI 2006).
Consumption patterns indicates that US workers
experience an unexpected drop in standard of
living after retirement. (Bernheim et. al 2001)
*Empoyee Benefit Research Instiute (EBRI) www.ebri.org
Consumption, Saving,
and Investment
An increase in consumption may not increase
aggregate demand if consumers substitute
consumption for saving.
A decrease in saving decreases business
investment.
Volatility of Investment
Investment is more volatile than output.
Investment tends to cluster in certain years,
but can have a long term impact.
Cooper, Haltwinger, and Power AER 1999 –
Sample of firms - 17% of investment over a 20
year span takes place in the “heaviest” year,
next heaviest year less than 12%.
Investment tends to correspond with peak
spending years.
Lags and Investment
It makes sense that investment is more
volatile.
There are time lags with investment – it takes
time to build new plants and equipment
Investment and GDP
Quarterly % Change
Desired Capital Stock
The desired capital stock is the equilibrium level of
capital spending (it maximizes profit for firms).
The level of the capital stock is determined in part by
the marginal product of capital – The additional benefit
of adding one more unit of capital.
However there is a lag in the investment in capital and
its impact on productivity – so we are actually looking
at the expected future Marginal Product of Capital
Finance 101
When will a firm invest in new capital?
When the marginal product of capital exceeds
the user cost of capital (think IRR>WACC)
The same type of principles apply here.
Marginal Product of Capital
As the capital stock increases each unit has a
lower benefit. In other words there are
diminishing marginal productivity of capital.
Expected Future Marginal Product of Capital
Marginal Product of Capital
Capital Stock
User Cost of Capital
The user cost of capital is the cost of using a
unit of capital for a specified period of time
Interest cost (the real interest rate x price of
capital goods)
Depreciation costs (the depreciation rate x the
price of capital goods)
Expected Future Marginal Product of Capital
Marginal Product of Capital
A
User Cost of Capital
B
Capital Stock
Desired Capital Stock
At A in the previous slide MPKf > uc it makes
sense for the firm to add to its capital stock
At B in the previous slide MPKf < uc the firm
should decrease its desired capital stock
The tax rate also impacts the relationship – The
after tax MPK should be compared to the after
tax uc.
Changes in Desired Capital Stock
The equilibrium level of capital stock will
change based on:
Price of capital
Real rate of interest
Marginal productivity of capital
Expected Future Marginal Product of Capital
Increased MPKf causes
Increased Desired Capital Stock
A
B
User Cost of Capital
Capital Stock
Tobin’s q
The value of the stock market plays a role in
consumers willingness to spend and save.
Similarly changes in the value of the stock
market may impact the desire of a firm to
invest (a wealth effect).
Therefore an increase in the value of the firm
should cause an increase in the desire to
invest.
Tobin’s q
The rate of investment depnds upon the ratio of
the capital’s market value (V) to its replacement
cost (Price of capital x capital stock)
V
Tobin' s q 
pk K
q and when to Invest
If q is greater than one, it implies that the
market is placing a higher value on the firms
assets than the cost of replacing the assets –
the firm should invest
If q is less than one the market is valuing the
firm’s assets at a price less than the cost of
replacing the assets – the firms should start
selling off assets
q and Fin 101 (IRR >WACC)
The return on investment can be measured by the
return on investment in new capital (basically the
ROC)
Profits
Replacemen t Cost of Capital
The required rate of return to shareholders can
provide a measure of the cost investing (ROE)
Profits
Stock Market Value of Firm
q and Fin 101 (IRR >WACC)
The ratio of the return on investing to the cost
should be greater than 1 (the return above the
cost) for the firm to invest
Profits
Replacemen t Cost of Capital
Profits
Stock Market Value of Firm
q and Fin 101 (IRR >WACC)
Profits
Stock Market Value of Firm
Profit
Replacemen t Cost of Capital
Market Value of Firm
q
Replacemen t Cost of Capital
Determinants of q
The same three factors in the original model
impact q
If MPKf increases future earnings increase
causing Firm Value to increase and q
If the real rate of interest decreases –
consumers substitute low yielding investment
for higher yielding investments – increasing
value and q
A decrease in purchase price of capital
increases q
Stock Prices and Investment
S&P 500 and Investment
The aggregate data does not show a strong
link between stock prices and investment.
Implications / Reasons
Firms do not find short term shifts in stock market
values to be informative OR
Firms concentrate too much on the short term
Intangible assts are also part of investment but are not
measured well.
Internal funds are major source of financing – current
cash flow (not future productivity) has an impact
Desired Capital Stock
and Investment
It= Gross investment in goods and services
Kt = Capital Stock at the beginning of the year
Kt+1 = Capital stock end of the year
d = depreciation
Net invest = Gross Invest – depreciation
Kt+1-Kt= It – dKt
Gross Invest = Net Invest + Depreciation
It = Kt+1-Kt + dKt
Replace K with
Desired Capital Stock K*
It = K*-Kt + dKt
Desired Net Increase in Capital Stock
Real Interest Rate
Future Marginal Productivity of Capital
Purchase price of Capital
Tax Rates
Goods Market Equilibrium
We stated that in a closed economy (no
trade) in other words that income and
spending were always equal
Y=C+I+G
Let Y be the quantity of goods and services
supplied by firms
Now on the RHS Substitute desired
consumption and desired investment (Cd & Id)
for C and I
Y = Cd + Id + G
Y = Quantity of goods supplied
Cd + Id + G = quantity of goods demanded
Unlike the GDP equation on the previous slide this will
not always be in equilibrium
For example, If firms produce too much output,
inventories increase I this case production exceeds
desired spending. The market will react to bring
the goods market back to equilibrium
Desired Saving and Desired Investment
Starting with Y = Cd + Id + G and rearranging
you get
Y - Cd –G = Id
Or
Desired Saving = Desired Investment
Goods Market Equilibrium
The real interest rate will move the goods
market toward equilibrium
Saving Decisions
Keeping everything else constant, if individuals
are rewarded with a higher return on their
investment, they will save more.
This implies a direct relationship between
saving and the quantity of dollars supplied (As r
increases s increases)
Graphing the Saving (Supply of Funds)
Function
S
Real
Interest
Rates
Level of
Saving
Saving Decisions
Last class we how a consumer decided to spend
(consume or save)
Saving Decision - An Individual’s decision to save or
consume at a given level of interest rates will
depend upon two main things:
Marginal Rate of Time Preference
Trading current consumption for future consumption
Income and wealth effects
Generally higher income – save more
A change in these variable will cause the level of
saving at each level of interest rates to change.
Graphing the Saving (Supply of Funds)
Function
An increase in the level of wealth
Real
Interest
Rates
S0
S1
Level of
Saving
Saving Decisions Summary*
An increase in
Saving will
Why?
Current Output
Rise
Saved for Fut Consumption
Expect Fut Output
Fall
Fut Income rises, save less today
Wealth
Fall
Some wealth is consumed, S
decreases at given Y
Expt Real Int Rate
Prob Rise
Opportunity cost of capital
Government Pur
Fall
Higher G Lowers S
Taxes
Unchanged
or Rise
* Abel and Bernanke
If taxes in fut are expected to
fall no change in saving, If tax
increase is perm S rises
MAcroeconomics
Investment Decisions
The reward for saving comes from business
being willing to pay interest for the funds they
borrow.
Keeping everything else constant, if business
is required to pay a higher level of interest
rates on its borrowing, it will borrow (and
invest) less.
This implies an inverse relationship between
the demand for funds by business and the
level of interest rates.
Graphing the Investment (Demand for Funds)
Function
Real
Interest
Rates
I
Saving / Investment
Determinants of Investment
An increase in
Real Interest Rate
Expected MPKf
Effective Tax Rate
Investment
will
Why
Fall
User cost of capital increases,
desired capital stock decreases
Rise
Each unit of capital provides
more output, at same cost,
desired capital stock increases
Fall
Tax adjusted user cost
increases, desired capital stock
falls
Note:
The availability of credit plays a role in both
consumption and investment (the yield spread
can serve as an indicator for this)
In part reflected by expected future real
interest rates
Increased borrowing may increase the user
cost of capital, even if the market rate does
not change
IPOs and venture capital play a key role in
small firms access to funds
Graphing the Investment (Demand for Funds)
Function
An increase in the Marginal Productivity of Capital
Real
Interest
Rates
D0
D1
Saving / Investment
Equilibrium
The level of interest rates will then be
determined by the intersection of the saving
(supply of funds) and investment (demand for
funds) functions.
At this intersection the demand for funds
equals the supply of funds. If demand does
not equal supply, the level of interest rates will
adjust.
Graphing the Saving (Supply of Funds)
Function
Real
Interest
Rate
S
r
I
S=I
Level of
Saving /Investment
Changes in Equilibrium
A change in the economy that causes a shift
in either the saving or investment function will
cause a change in the general level of interest
rates.
For example: What if new technology
increases the productivity of capital?
The demand for funds will be higher at each
level of interest rates. At the original r,
Investment > Savings so real interest rates
will increase as firms compete to attract funds.
Note:
So far we have not included international trade.
The equilibrium will be impacted by foreign
savers and the ability for Domestic consumers
to save abroad. (we will cover this soon)
Measuring Investment
NIPA tables
Economic Indicators
Factory Orders
Business Inventories
Capacity Utilization and Industrial Production
The IS Curve
Equilibrium in the Goods Market
The goods market is in Equilibrium when
Aggregate Supply = Aggregate Demand
Or in a closed economy (see Investment Notes)
Starting from Y = Cd + Id +G and rearranging
Id= Y - Cd – G
Desired National Investment is equal to Desired
National Saving (Id = Sd)
Review
Saving = Investment
Real Interest Rate, r
Desired
Saving
Desired
Investment
Id,Sd
Investment and Saving, Id,Sd
Saving Decisions
Earlier we showed how a consumer decided to use
income (consume or save)
Saving Decision - An Individual’s decision to save or
consume at a given level of interest rates will
depend upon two main things:
Marginal Rate of Time Preference
Trading current consumption for future consumption
Income and wealth effects
Generally higher income – save more
A change in these variable will cause the level of
saving at each level of interest rates to change.
Graphing the Saving
(Supply of Funds) Function
An Increase in the Level of Output
Real
Interest
Rates
Old Desired
Saving, S0
New Desired
Saving,S1
Level of Saving
Saving Decisions Summary*
An increase in
Saving will
Current Output
Rise
Expect Fut Output
Fall
Why?
Saved for Fut Consumption
Fut Income rises, save less today
Wealth
Fall
Some wealth is consumed, S
decreases at given Y
Expt Real Int Rate
Government Pur
Prob Rise
Fall
Opportunity cost of capital
Taxes
Unchanged
or Rise
If taxes in fut are expected to
fall no change in saving, If tax
increase is perm S rises
Higher G Lowers S
* Abel and Bernanke Macroeconomics
The IS curve
The level of saving at each level of real interest
rate increases with the level of output (national
income).
The IS curve is found by graphing the
combinations of Y and r – In other words for a
series of output levels, Y, find the
corresponding equilibrium level of real interest
rates r and then graph the combinations of Y
and r (Y,r)
Example
Assume that at a level of output equal to 8000
the level of real interest rates is 7%
If the level of output increases to 9000 you can
find the equilibrium level of real interest rates
from the Saving Investment diagram, lets say
the new level of rates is 6%
Equilibrium in Goods Market
At Various Output Levels
Real Interest Rate
An Increase in the Level of Output
Desired Saving,
Y0=8000
Desired Saving,
Y1=9000
r0=7%
r1=6%
Id
Level of Saving
Real Interest
Rate, r
Deriving the IS curve
S0(Y=8000)
S1(Y=9000)
7%
7%
6%
6%
IS
Id
Id,Sd
8000 9000
Y
Notes on IS
At each point on the IS curve
Desired Investment = Desired Saving
This is the same point where Aggregate goods
supplied equals Aggregate Goods Demanded
(Closed Economy)
The level of Interest Rates where Id =Sd is also
the place where
Id=Y - C – G or Y =C + Id + G
Intuition
Assume that the economy was initially at Y0=
8000 and the level of output increased to Y1 =
9000.
At the new level of output consumption and
investment both increase
At the old level of rates 7% the amount of
saving is greater than the amount of
investment, the real level of rates will decrease.
Shifts in IS Curve
The IS curve shows the level of interest rates
needed for goods market equilibrium at each
level of output.
Keeping Output Constant – Any decrease in
Desired Saving relative to Desired Investment
will cause the IS curve to shift up and vice
versa.
Intuition
A decrease in the supply of funds (Saving) with
the same demand for funds (Investment) has
caused a higher level of real interest rate at
each level of output.
There is a shortage of funds compared to the
demand for funds so the level of real interest
rates increases (assuming the same investment
function).
Example:
An Increase in Government Spending
We showed in the investment notes that an
increase in government spending will cause a
decline in the amount of saving at each level
of output.
Id=Y – C- G(h)
This would decrease the level of saving at each
level of real interest rates
Real Interest Rate
Equilibrium in Goods Market
An Increase in Government Spending
S1(Y0)
S0(Y0)
r1
r0
Id
Level of Saving
Adjustment to Equilibrium
At the original real level of interest rates
Sd<Id
To bring the market back to equilibrium the
level of interest rates increases
As the level of rates increases the amount of
investment declines along the Id curve until
new equilibrium is reached
Equilibrium in Goods Market
An Increase in Government Spending
Real Interest Rate
S1(Y0)
S0(Y0)
r1
r0
Id
S*=I*
Sd
<
Level of Saving
Id
A Shift in the IS Curve
Increased Government Spending
Real Interest
Rate, r
S1(Y0)
S0(Y0)
r1
r1
r0
IS1
r0
Id
S*=I* S0=I0
Id,Sd
IS0
Y0
Another Interpretation
Our model above showed that the IS shifted up
at each level of output.
Alternatively you could have said that the IS
curve shifted right at each level of interest
rates. This implies that the change increased
the level of aggregate demand.
Y = Cd + Id + G(h)
Notes
Our example is based on the intuition in the
loanable funds market. You can arrive at the
same function in several different ways. The
book assumes an exogenous change in interest
rates that impacts both the Investment and
Saving Functions but by different amounts –
still graphing the relationship between Y and r.
Shifts in IS
An Increase in
Shifts IS
Reason
Expect Fut Y
Up (Right)
Desired Saving Falls (Ch)
Wealth
Up (Right)
Desired Saving Falls (Ch)
Gov’t Spending
Up (Right)
Desired Saving Falls (Ch)
Taxes
No Change or
Down (Left)
No Change, if consumers expect future
tax cut
Down if consumers iC causing Sh
Marginal Prod Cap
Up (Right)
Id h causing r to increase
Effect Tax on Cap
Down (Left)
Id i causing r to decrease
Bus Sentiment
Up (Right)
Id h causing r to increase