CH15:xpectations, Consumption, and Investment

What are the three main types of wealth that affect consumption decisions?

Financial wealth, housing wealth (together: nonhuman wealth), and human wealth

What is "permanent income"?

It’s the expected average income over a lifetime, based on talent, skills, and future job prospects, not current income.

How does perfect foresight affect consumption?

Individuals spread consumption evenly over time by borrowing early and saving later

What causes consumption to deviate from being smooth over time?

Imperfect foresight, financial market imperfections, unemployment, and health shocks

What happens to consumption if a bonus is considered transitory?

Consumption changes little; most of the bonus is saved

Why can’t banks lend based on human wealth?

Due to asymmetric information, banks use current disposable income as a proxy

What is investment, economically speaking?

Using funds today to buy capital goods that yield future returns (cash flows)

When will a firm invest in a project?

If the present value of expected profits exceeds the cost of the investment

What is Tobin’s Q?

Q= market value of firm/replacement cost of capital ; if q>1, invest

How do expectations affect investment decisions?

Through expected profits and expected interest rates, which affect present value

What role does cash flow play in investment?

Firms with low current cash flow may be unable to invest, even with profitable opportunities.

What is the user cost of capital?

The sum of interest rate and depreciation: r +δ

How do consumption and investment react to temporary changes in income or sales?

They change little; expectations of permanence matter more

Why is investment more volatile than consumption?

Because investment reacts strongly to expectations about future profits and output

How do both consumption and investment contribute to output fluctuations

Despite consumption being a larger part of GDP, investment’s higher volatility balances their contributions