Chapter 12 Microfoundations

1
CHAPTER Microfoundations
of Consumption and
Investment
12
2
Microfoundations

• The Role of Microfoundations
• Consumption
• Investment
• Present Value
• Consumption
• Permanent Income Hypothesis
• Life Cycle Hypothesis

3
Microfoundations

• Investment
• Marginal Efficiency of Investment
• The Investment Decision
• Adjusting for Risk
• Financing Investment Expenditures
• Bonds
• Stocks

4
Microfoundations

• The study of microfoundations is the development
  of macroeconomic relationships from an analysis
  of individual decisions.
• Microfoundations are important in understanding
  consumption and investment.
• Microfoundations focus on how people and
  businesses make intertemporal choices.

5
Present Value

• Present value (PV) is the amount of money that
  you would need to save now for a certain number
  of years (n) at the stated interest rate (r) in
  order to accumulate a certain amount in the
  future (FV).

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Present Value

The present value of 10,000 received 5 years in
the future at 5 interest is
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Present Value of 10,000 at 5
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Present Value of a Flow of Payments
The present value of a flow of payments is the
sum of their present values.
For example, the present value of 10,000
received at the end of each of the next 5 years
at 5 is
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Present Value Relationships

• The present value of a future sum of money varies
  inversely with the interest rate.
• The present value of a given sum of money
  declines the further into the future the money is
  to be received.

10
Consumption

• John Maynard Keynes first introduced the
  consumption function in 1936 in his book, The
  General Theory of Employment, Interest, and
  Money.
• Consumption depends on disposable income (Yd) and
  other factors, or autonomous consumption, C0.
• C C0 mpcYd

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Relationship Between Short and Long-Run
Consumption
CLR
C2SR
C1SR
?
Consumption
C0SR
?
?
Disposable Income
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Consumption Theories

• Two important microfoundation theories that
  explain the difference between long-run and
  short-run consumption functions
• permanent income theory
• life cycle hypothesis
• Both theories assume that people base their
  present and future consumption decisions and
  current and expected future income.

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Permanent Income Hypothesis

• The permanent income hypothesis says that people
  base their consumption decisions on the present
  value of their expected future income.
• In years when income is temporarily high, people
  save most of the temporary portion.
• In years when income is temporarily low, people
  borrow to maintain their level of spending.

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Permanent Income
Consumption is based on YP, permanent income.
Permanent income is the annual average of the
present value of future income.
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Life Cycle Hypothesis

• The life cycle hypothesis says that people try to
  even out their consumption expenditures over
  their lifetime.
• During their working years, income exceeds
  consumption and people save and accumulate
  assets.
• At retirement, people begin to dissave, drawing
  down their accumulated assets.

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Life Cycle Hypothesis
Income
Saving
Consumption
Saving, Consumption
Consumption
Dissaving
Working years
Retirement
Wealth
Decumulation
Accumulation
Working years
Retirement
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Life Cycle Hypothesis and the Facts

• The Elderly Dont Dissave as Much as the Model
  Predicts
• Lifespans are uncertain and people are hesitant
  to dissave too quickly and risk exhausting their
  savings
• People may want to leave an inheritance
• People do not smooth out their consumption as
  much as the model predicts
• People dont know how to forecast future income
• People are liquidity constrained

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Policy Implications of Permanent Income and Life
Cycle Hypotheses

• Policies that are permanent have more effect on
  the economy than temporary ones.
• Monetary policy impacts the economy through the
  wealth effect
• Expansionary monetary policy raises interest
  rates, increases investor confidence, and raises
  stock prices, which increases wealth and
  consumption.

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The Investment Decision

• Firms invest if the marginal efficiency of
  investment (mei) ? their relevant interest cost
• The mei is the rate of return that makes a
  projects cash flows equal to its initial cost.

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Calculation of the MEI
If a project costs 100 today and will result in
a cash flow of 40 at the end of each of the next
3 years, the mei is
mei 9.5
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Adjusting for Risk

• To estimate the returns of a risky project, firms
  estimate the probabilities of a projects success
  and determine the projects expected value (EV).
• For example, if Furby has a 1 chance of making
  1,000,000 and a 99 chance of making nothing,
  its expected value is
• EV 0.01(1,000,000) .99(0) 10,000

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Methods of Financing Investment

• Debt Financing
• Issue bonds
• Borrow from the bank
• Equity Financing
• Issue stock
• Retained Earnings
• Net income not paid out to stockholders as
  dividends

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Bond Prices and Interest Rates
The value of a bond is the present value of its
interest payments and principal.
If a bond that matures in 2 years pays 10
interest and has a 100 face value, with a 12
interest rate on similar bonds, its price is
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Bond Yields
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Stock Prices
Stock prices reflect the present value of the
future stream of profits per share that a firm
is expected to earn over its lifetime, adjusted
for the riskiness of that return.
If the interest rate is 5 and expected profit
per share is 10, the price of the stock is 200.
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Beta A Risk Rating for Stock

• A stocks beta measures the relationship between
  the rate of return on a particular stock and the
  rate of return on the market as a whole.
• Returns of a stock with a beta of 1 move
  one-for-one with the market and the stock is as
  risky as the market.
• A stock with a beta more than one varies more
  than the market and is more risky than the
  market a beta less than one is less risky.

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Tobins-q
The numerator is the markets expectation of
future profits generated by the firms present
capital.
The denominator is the cost of replacing that
capital.
If q is greater than 1, the value of existing
capital in terms of its potential to earn
profitgtcost of capital and the firm should add
invest in more capital.
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PE Ratios
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Policy Implications of the Microfoundations of
Investment

• Permanent tax credits are likely to have a larger
  impact on investment than temporary tax curs
  because investment depends on the expected value
  of all future profit flows.
• Monetary policy affects investment through its
  effect on the stock market.

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Lifetime Consumption Possibilities
160,400
B
?
This lifetime budget constraint line shows all
possible combinations of consumption during the
first and second periods of life.
Second Period Consumption
A
12,000
?
C
?
151,320.8
140,000
First Period Consumption
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Lifetime Consumption Possibilities
Second Period Consumption
q
w
C20
z
y
C21
I1
I2
C11
C10
First Period Consumption
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Shape of the Indifference Curve
A
40,000
Second Period Consumption
B
35,000
C
30,000
47,000
40,000
57,000
1. Sandy will accept 5000 less income during
the second period.
2. if she is given 7000 more income in the first
period.
First Period Consumption
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Optimal Consumption Choice
Sandy maximizes happiness by choosing a
combination of consumption at point A.
Second Period Consumption
A
77,864.09
77,864.09
First Period Consumption
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Temporary Increase in Income
1. An increase in income during period 1...
Second Period Consumption
2. is spread out to increase consumption in both
periods.
B
78,893.21
A
77,864.09
77,864.09
78,893.21
First Period Consumption
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Permanent Increase in Income
1. An increase in income during both periods...
2. Leads to increases in consumption during both
periods that equal the rise in income.
Second Period Consumption
B
79,864.09
A
77,864.09
77,864.09
79,864.09
First Period Consumption