Chapter 16: Expectations, Consumption, and Investment

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Chapter 16 Expectations, Consumption, and
Investment

• 16-1 Consumption
• 16-2 Investment
• 16-3 The Volatility of Consumption and
  Investment
• Appendix Derivation of the Expected Present
  Value of Profits when Future Profits and Interest
  Rates Are Expected to be the Same as Today

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16-1 Consumption

• The Very Foresighted Consumer
• An Example
• Toward A More Realistic Description
• Putting Things Together Current Income,
  Expectations, and Consumption

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The Very Foresighted Consumer

• Calculate total wealth
• Total W. Human W. Non-Human W.
• Human Wealth is the present value of expected
  future after-tax income
• Non-Human Wealth is the current value of housing
  and other financial assets
• Then, consume some fixed proportion of total
  wealth
• This will allow consumption to be smoothed
• Total wealth might grow or decline, depending on
  rates

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An Example

• Before tax salary of 40K
• Starting in 3 years, and continuing for 37 more
• Real raises of 3 per year every year
• 25 of your income paid as taxes
• Your human wealth is just under 2 Million
• Divide that equally by a life expectancy of 56
  years to obtain 36K which is what you can
  consumer annually
• Borrow now to start enjoying that level of
  spending!

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Toward A More Realistic Description

• So.why dont you borrow that money now?
• Some people do student loans, auto loans,
  mortgages and so on
• More realistically, people base a lot of their
  consumption decision on their current income
• Many people under-consume when young, and
  over-consume when old.

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Putting Things Together Current Income,
Expectations, and Consumption

• The most critical part of the entire consumption
  problem is the expectations about the future.
  Therefore
• Consumption is not as volatile as current income
• Getting laid off doesnt change peoples
  perception of their total wealth much
• Consumption can change when income is steady if
  people become less confident
• This is what happened in 1990-1

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16-2 Investment

• Investment and Expectations of Profit
• A Convenient Special Case
• Current versus Expected Profit
• Profit and Sales

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Investment and Expectations of Profit

• When do you invest in a new machine?
• Assume or calculate a depreciation rate
• Calculate the present value of future profits
• Discount profits by depreciation
• Discount them again by the interest rate
• Investment is related positively to this present
  value

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Investment and Expectations of Profit Contd.

• Tobins q statistic is a good way to track this
• q is the ratio of the present value of expected
  future profits from a machine, divided by its
  purchase price
• Tobins q is a good predictor of investment
  spending in the near future

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A Convenient Special Case

• Since firms have an infinite lifetime, the
  discounting formula can be drastically simplified
  by assuming
• The same rate of discount every year
• The same rate of depreciation every year
• The present value of expected future profits is
  then today profits, divided by the sum of the
  discount and depreciation rates
• That sum is known as the user cost of capital

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Current versus Expected Profit

• Just like consumption, investment appears to be
  too sensitive to current profit, and as sensitive
  as it should be to expected future profits
• Many managers are reluctant to borrow against
  expectations
• Many lenders have trouble monitoring expectations
  of future profit accurately
• Agency costs are the name given to this problem
• Current profits reduce agency costs, and
  therefore increase the likelihood of getting a
  loan

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Profit and Sales

• The behavior or profits varies a lot between
  industries and firms
• However, within a single particular firm, profits
  are tightly related to sales
• Sales are related to overall economic performance
  which is highly persistent
• Therefore, good sales today will be correlated
  with good sales in the future, leading to
  investment today

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16-3 The Volatility of Consumption and Investment

• Investment is something like 3 times as volatile
  as consumption. This is because
• Consumption decisions are made in response to
  changes in expected future income, and thus they
  change more or less in proportion
• Investment decisions are made to support and
  create expected future profit so they are often
  made in a lump-sum at one point in time to
  support a stream of future sales

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Appendix Derivation of the Expected Present
Value of Profits when Future Profits and Interest
Rates Are Expected to be the Same as Today

• Not required