Business, Government, and the World Economy

1
Business, Government, and the World Economy

• Consumption, Saving Investment

2
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

3
Consumption

• Average or expected income of consumers
• Cost and availability of credit
• The Decision to save vs. spend

4
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

5
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

6
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.

7
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

8
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.

9
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.

10
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

11
Quarter to Quarter Results
12
(No Transcript)
13
Yearly Changes
14
Yearly Change
15
3 year Change
16
3 year change
17
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)

18
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

19
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

20
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 gt Output (income)
• Inventories decline production increases
• When output is greater than y
• Planned Spending lt Output (Income)
• inventories increase, production increases.

21
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

22
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

23
PIH

• Consumption is based on expected or permanent
  income, not just current income.

24
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).

25
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
• (1r)(Y1-C1)
• The total amount available to spend in year 2 is
  then
• C2 Y2 (1r)(Y1-C1)

26
C2 Y2 (1r)(Y1-C1)

• Rearrange
• C2 (1r)(C1) Y2 (1r)(Y1)
• Divide by 1r
• C1 C2/(1r) Y1Y2/(1r)
• The PV of consumption must equal the PV of
  income -- in other words the key constraint on
  consumption is your lifetime income.

27
Intertemporal Budget Constraint

• Graph period 2 consumption on vertical axis (max
  value Y1(1r) Y2)
• Graph period 1 consumption on horizontal axis
  (Max value Y1Y2/(1r))
• Combine budget constraint with indifference
  curves (combinations of consumption with same
  utility)

28
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.

29
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

30
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.

31
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.

32
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

33
Life Cycle Model
Entrance to Workforce
Retirement
Age
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Implications of Life Cycle ModelSaving 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.

35
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.

36
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)

37
Some real world dataIs 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)

38
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.

39
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.

40
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

41
Investment and GDPQuarterly Change
42
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

43
Finance 101

• When will a firm invest in new capital?
• When the marginal product of capital exceeds the
  user cost of capital (think IRRgtWACC)
• The same type of principles apply here.

44
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.

45
Marginal Product of Capital
Expected Future Marginal Product of Capital
Capital Stock
46
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)

47
Marginal Product of Capital
A
Expected Future Marginal Product of Capital
User Cost of Capital
B
Capital Stock
48
Desired Capital Stock

• At A in the previous slide MPKf gt uc it makes
  sense for the firm to add to its capital stock
• At B in the previous slide MPKf lt 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.

49
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

50
Increased MPKf causes Increased Desired Capital
Stock
Expected Future Marginal Product of Capital
A
B
User Cost of Capital
Capital Stock
51
Tobins 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.

52
Tobins q

• The rate of investment depnds upon the ratio of
  the capitals market value (V) to its replacement
  cost (Price of capital x capital stock)

53
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
  firms assets at a price less than the cost of
  replacing the assets the firms should start
  selling off assets

54
q and Fin 101 (IRR gtWACC)

• The return on investment can be measured by the
  return on investment in new capital (basically
  the ROC)
• The required rate of return to shareholders can
  provide a measure of the cost investing (ROE)

55
q and Fin 101 (IRR gtWACC)

• 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

56
q and Fin 101 (IRR gtWACC)
57
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

58
Stock Prices and Investment
59
SP 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

60
Desired Capital Stock and Investment

• It Gross investment in goods and services
• Kt Capital Stock at the beginning of the year
• Kt1 Capital stock end of the year
• d depreciation
• Net invest Gross Invest depreciation
• Kt1-Kt It dKt
• Gross Invest Net Invest Depreciation
• It Kt1-Kt dKt

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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
62
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

63
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

64
Desired Saving and Desired Investment

• Starting with Y Cd Id G and rearranging you
  get
• Y - Cd G Id
• Or
• Desired Saving Desired Investment

65
Goods Market Equilibrium

• The real interest rate will move the goods market
  toward equilibrium

66
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)

67
Graphing the Saving (Supply of Funds) Function
S
Real Interest Rates
Level of Saving
68
Saving Decisions

• Last class we how a consumer decided to spend
  (consume or save)
• Saving Decision - An Individuals 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.

69
Graphing the Saving (Supply of Funds) Function
An increase in the level of wealth
Real Interest Rates
S0
S1
Level of Saving
70
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 If taxes in fut are expected to fall no change in saving, If tax increase is perm S rises
71
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.

72
Graphing the Investment (Demand for Funds)
Function
Real Interest Rates
I
Saving / Investment
73
Determinants of Investment
An increase in Investment will Why
Real Interest Rate Fall User cost of capital increases, desired capital stock decreases
Expected MPKf Rise Each unit of capital provides more output, at same cost, desired capital stock increases
Effective Tax Rate Fall Tax adjusted user cost increases, desired capital stock falls
74
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

75
Graphing the Investment (Demand for Funds)
Function
An increase in the Marginal Productivity of
Capital
Real Interest Rates
D1
D0
Saving / Investment
76
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.

77
Graphing the Saving (Supply of Funds) Function
Real Interest Rate
S
r
I
Level of Saving /Investment
SI
78
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
  gt Savings so real interest rates will increase as
  firms compete to attract funds.

79
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)

80
Measuring Investment

• NIPA tables
• Economic Indicators
• Factory Orders
• Business Inventories
• Capacity Utilization and Industrial Production

81
The IS CurveEquilibrium 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)

82
Review Saving Investment
Desired Saving
Real Interest Rate, r
Desired Investment
Investment and Saving, Id,Sd
Id,Sd
83
Saving Decisions

• Earlier we showed how a consumer decided to use
  income (consume or save)
• Saving Decision - An Individuals 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.

84
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
85
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 If taxes in fut are expected to fall no change in saving, If tax increase is perm S rises
86
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)

87
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

88
Equilibrium in Goods MarketAt Various Output
Levels
An Increase in the Level of Output
Desired Saving, Y08000
Desired Saving, Y19000
Real Interest Rate
r07
r16
Id
Level of Saving
89
Deriving the IS curve
S0(Y8000)
Real Interest Rate, r
S1(Y9000)
7
7
6
6
IS
Id
Y
9000
Id,Sd
8000
90
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
• IdY - C G or Y C Id G

91
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.

92
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.

93
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).

94
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.
• IdY C- G(h)
• This would decrease the level of saving at each
  level of real interest rates

95
Equilibrium in Goods MarketAn Increase in
Government Spending
S1(Y0)
S0(Y0)
Real Interest Rate
r1
r0
Id
Level of Saving
96
Adjustment to Equilibrium

• At the original real level of interest rates
• SdltId
• 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

97
Equilibrium in Goods MarketAn Increase in
Government Spending
S1(Y0)
S0(Y0)
r1
Real Interest Rate
r0
Id
SI
Level of Saving
Sd lt Id
98
A Shift in the IS CurveIncreased Government
Spending
S1(Y0)
Real Interest Rate, r
S0(Y0)
r1
r1
IS1
r0
r0
Id
IS0
Id,Sd
S0I0
Y0
SI
99
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)

100
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.

101
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)
Govt 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