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Households: Consumption and Labor Supply DecisionsThe 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 EmploymentDecisions
Expectations and Animal SpiritsProfit MaximizationExcess Labor and Excess Capital EffectsInventory InvestmentA Summary of Firm BehaviorThe Firm Sector Since 1970
Productivity and the Business Cycle
The Short-Run Relationship BetweenOutput and Unemployment
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.
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.
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.
Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
The Wage Rate
Households make consumption and labor supply decisions simultaneously. 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.
According to the substitution effect of a wage rate increase, a higher wage leads to a larger quantity of labor supplied—a larger workforce.
According to the income 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.
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.
Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Wealth and Nonlabor Income
nonlabor, or nonwage, income Any income received from sources other than working— inheritances, interest, dividends, transfer payments, and so on.
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.
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.
Households: Consumption and Labor Supply Decisions
Interest Rate Effects on Consumption
A rise in the interest rate leads me to consume less today and save more. This effect is called the substitution effect of an interest rate change.
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.
Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
In Keynesian theory, current income determinescurrent consumption. It is incorrect to think consumption depends only on income, at least when there is full employment. However, if there is unemployment, Keynes is closer to being correct because income is not determined by households. When there is unemployment, the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms.
Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970
Housing Investment
Housing investment fell during the four 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–2007 IV
Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970
Labor Supply
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–2007 IV
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, 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.
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).
productivity, or labor productivity Output per worker hour; the amount of output produced by an average worker in 1 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 figures can be misleading when used to diagnose the health of the economy over the short run, because business cycles can distort the meaning of productivity measurements. Output per worker falls in recessions because firms hold excess labor during slumps. Output per worker rises in expansions because firms put the excess labor back to work. Neither of these conditions has anything to do with the economy’s long-run potential to produce output.
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.
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.