Expectations,

Consumption,
and Investment
Consumption
The theory of consumption was
developed by Milton Friedman
in the 1950s, who called it the
permanent income theory of
consumption, and by Franco
Modigliani, who called it the life
cycle theory of consumption.
The Very Foresighted Consumer
A very foresighted consumer who decide how
much to consume based on the value of his
total wealth, which comprises:
The value of his nonhuman wealth, or the sum of
financial wealth and housing wealth.
The value of his human wealth, or the present
value of expected after-tax labor income.
C C total weal
t
= ( ) th
t
Toward a More Realistic Description
The constant level of consumption that a
consumer can afford equals his total wealth
divided by his expected remaining life.
Consumption depends not only on total wealth
but also on current income.
C C total weal Y T
t LT t
= ( , ) th
t
Y T
LT t
=
human wealth, or the expected present
value of after-tax labor income
T
t
=
real taxes in year t.
Y
Lt
=
real labor income in year t.

Wealth
Consumer and saving habits
Size of the population
Income distribution
Credit availability
Expectations of change in prices
Expectations of future income
Interest rates
Shifts in the consumption function

Educational attainment of the head of the family and its
members

Family size

Household Savings:

Income (permanent and transitory)
Interest rates
Exchange rates (real effective exchange rates)
Depreciation of the RUPEE
Appreciation of the RUPEE

Determinants of family income:

Engels Law (Ernst Engel)
There is a relationship between the amount of income
and proportionate changes in consumption
expenditures as income level shifts.

As the income of the family increases:
A smaller percentage is spent for food
Approximately the same for clothing
Constantly increasing percentage spent for education, health,
recreation, amusement, travel
Approximately the same percentage for rent, fuel and light.
Putting Things Together: Current Income,
Expectations, and Consumption
Expectations affect consumption in two ways:

Directly through human wealth, or expectations of
future labor income, real interest rates, and taxes.

Indirectly through nonhuman wealthstocks,
bonds, and housing. Expectations of the value of
nonhuman wealth is computed by financial
markets.
Putting Things Together: Current Income,
Expectations, and Consumption
Consumption is likely to respond less than one
for one to fluctuations in current income.
Consumption may decrease one for one with a
decrease in income only if the decrease in income is
considered to be permanent.
Temporary changes in current income, such as those
caused by recessions and expansions, are unlikely to
increase consumption by as much as income.
Consumption may move even if current income
does not due to changes in consumer
confidence.
Investment
Gross Investment
= Net Investment + Depreciation
Investment (flow variable)
Durable equipment, new buildings, increase in
inventories
Capital (stock variable)
Equal to the amount of accumulated investment as
of a given point in time.
Investment
Investment decisions depend on current sales,
the current real interest rate, and on
expectations of the future.
The decision to buy a machine depends on the
present value of the profits the firm can expect
from having this machine versus the cost of
buying it.
Determinants of Investment:
Business Investment in durable equipment
Rate of profit
Interest rate
Changes in expectations
Rate of innovation
Rate of change in output
Inventory Investment
Rate of increase in sales
Residential construction
Change in income levels
Cost of construction
Availability and cost of housing credit
Investment and Expectations of Profit
Depreciation:
The rate of depreciation, measures how much
usefulness the machine loses from one year
to the next.
Reasonable values are between 4 and 15%
for machines, and between 2 and 4% for
buildings and factories.
Investment and the Stock Market
James Tobin argued that there should be a
tight relation between the stock market and
investment.
The stock price tells firms how much the stock
market values each unit of capital already in
place; thus, the willingness to pay for one
more unit. If the stock market value exceeds
the purchase price, the firm should buy the
machine.
Profitability Versus Cash Flow
Profitability refers to the expected present
discounted value of profits.
Cash flow refers to current profit, or the net
flow of cash the firm is receiving.
Both profitability and cash flow are important
for investment decisions, and are likely to
move together.
Profits and Sales
Changes in Profit and
Changes in the Ratio
of Output to Capital in
the United States,
1960-2000
H H
t
t
t
Y
K
=
|
\

|
.
|
Profit and the ratio of
output to capital move
largely together.
The Volatility of
Consumption and Investment
Investment is more volatile than consumption.

Consumption and investment usually move
together. Both components contribute roughly
equally to fluctuations in output over time.