1 of 28. 2 of 28 © 2014 Pearson Education, Inc. 3 of 28 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 16 Household and Firm Behavior in the Macroeconomy:

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CHAPTER OUTLINE

16Household and Firm Behavior in the

Macroeconomy: A Further Look* Households: Consumption and Labor

Supply Decisions The Life-Cycle Theory of ConsumptionThe Labor Supply DecisionInterest Rate Effects on ConsumptionGovernment Effects on Consumption and Labor Supply: Taxes and TransfersA Possible Employment Constraint on HouseholdsA Summary of Household BehaviorThe Household Sector Since 1970

Firms: Investment and Employment Decisions

Expectations and Animal SpiritsExcess Labor and Excess Capital EffectsInventory InvestmentA Summary of Firm BehaviorThe 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!

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life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their expectations of lifetime income.

Households: Consumption and Labor Supply Decisions

The Life-Cycle Theory of Consumption

permanent income The average level of a person’s expected future income stream.

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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.

FIGURE 16.1 Life-Cycle Theory of Consumption

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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.

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.

The Labor Supply Decision

The Wage Rate

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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.

Prices

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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.

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.

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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.

Interest Rate Effects on Consumption

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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.

Government Effects on Consumption and Labor Supply: Taxes and Transfers

Transfer payments are payments such as Social Security benefits, veterans’ benefits, and welfare benefits.

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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.

A Possible Employment Constraint on Households

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Recall the Keynesian theory that current income determines current consumption.

Both consumption and labor supply decisions depend on the real wage rate, but if there is unemployment, it is income, not the wage rate, that affects consumption.

Developed during a period of unemployment, Keynesian theory is considered to pertain to such periods.

Keynesian Theory Revisited

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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

A Summary of Household Behavior

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Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable goods.

FIGURE 16.2 Consumption Expenditures, 1970 I–2012 IV

The Household Sector Since 1970

Consumption

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Housing investment fell during the five recessionary periods since 1970.Like expenditures for durable goods, expenditures for housing investment are postponable.

FIGURE 16.3 Housing Investment of the Household Sector, 1970 I–2012 IV

Housing Investment

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One way to measure housing price changes is to look at changes in the average price of a house in a city over time.

An alternative is to try to standardize the house type, say looking at the change in the average price of a four-bedroom house in an area over time.

Karl Case, working with Robert Shiller, a behavioral finance economist, developed an index that neatly solves the problem that houses are all different.

The Case-Shiller index looks only at houses that have sold multiple times and asks the question: How much does an identical house sell for now versus in the past?

Measuring Housing Price Changes

E C O N O M I C S I N P R A C T I C E

THINKING PRACTICALLY

1. Who, other than macroeconomists, might be interested in trading the Case-Schiller index?

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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).

FIGURE 16.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2012 IV

Labor Supply

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animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings.

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.

Firms: Investment and Employment Decisions

Expectations and Animal Spirits

The Accelerator Effect

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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.

Excess Labor and Excess Capital Effects

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inventory investment The change in the stock of inventories.

Stock of inventories (end of period) = Stock of inventories (beginning of period)

+ Production − Sales

Inventory Investment

The Role of Inventories

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).

The Optimal Inventory Policy

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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

A Summary of Firm Behavior

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.

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Overall, plant-and-equipment investment declined in the five recessionary periods since 1970.

FIGURE 16.5 Plant-and-Equipment Investment of the Firm Sector, 1970 I–2012 IV

The Firm Sector Since 1970

Plant-and-Equipment Investment

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Growth in employment was generally negative in the five recessions the U.S. economy has experienced since 1970.

FIGURE 16.6 Employment in the Firm Sector, 1970 I–2012 IV

Employment

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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.

FIGURE 16.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2012 IV

Inventory Investment

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productivity, or labor productivity Output per worker hour.

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.

FIGURE 16.8 Employment and Output over the Business Cycle

Productivity and the Business Cycle

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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.

The Short-Run Relationship Between Output and Unemployment

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.

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.

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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 people’s expectations about the future.

In practice, the multiplier probably has a value of around 2.0.

Its size also depends on how long ago the spending increase began.

The Size of the Multiplier

The Size of the Multiplier in Practice

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accelerator effect

adjustment costs

animal spirits of entrepreneurs

constrained supply of labor

desired, or optimal, level of inventories

discouraged-worker effect

excess labor, excess capital

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

R E V I E W T E R M S A N D C O N C E P T S