Consumption and investment

According to the lecture, which two components of private sector demand are being analyzed?

The lecture focuses on Consumption (C) and Investment (I).

What is the primary reason that consumption is typically much less volatile than investment?

Consumption is less volatile due to consumption smoothing, where individuals save in good times and borrow or use savings in bad times to maintain a stable consumption level.

In the two-period consumption model, what does the choice in period 1, $C1 + S1 = Y_1$, represent?

It represents the allocation of income in period 1 ($Y1$) between consumption ($C1$) and saving ($S_1$).

What does the equation $C2 = Y2 + (1+r)S_1$ represent in the two-period consumption model?

This is the intertemporal budget constraint (IBC), showing that consumption in period 2 ($C2$) is funded by income in period 2 ($Y2$) plus savings from period 1 with interest ($S_1(1+r)$).

In the intertemporal consumption model, who is a typical example of a 'borrower'?

A student, who has a low income today ($Y1$) but expects a high future income ($Y2$), is a typical example of a borrower.

In the intertemporal consumption model, who is a typical example of a 'lender'?

A professional athlete, who has a high income today ($Y1$) but expects a lower future income ($Y2$), is a typical example of a lender.

According to the theory of intertemporal choice, what does an individual do in response to a temporary increase in income today ($Y_1$)?

Following a temporary income increase today, the individual will save a portion of it to finance higher consumption in both the present and the future.

According to the theory of intertemporal choice, what does an individual do in response to an expected temporary increase in income tomorrow ($Y_2$)?

Expecting a temporary income increase tomorrow, the individual will borrow today to increase current consumption and pay back the debt tomorrow.

What is the term for the behavior of saving in good times and borrowing or drawing on savings in bad times to maintain stable consumption?

This behavior is known as consumption smoothing.

How does a permanent income change affect consumption compared to a temporary income change?

A permanent income change leads to a much larger change in consumption in both periods, as it affects lifetime wealth more significantly than a temporary change.

What is the core idea of the Random Walk Consumption Theory?

It posits that consumption depends on lifetime wealth, which only changes with new, unpredictable information, making changes in consumption themselves unpredictable.

The random walk theory of consumption can be expressed by the formula $ct = c{t-1} + \epsilont$. What does $\epsilont$ represent?

$\epsilon_t$ represents the 'news' or unpredictable shock to wealth/income in period t, which causes consumption to change.

What is the basic idea of the Life-Cycle Consumption Hypothesis, developed by Modigliani?

Individuals use saving and borrowing to smooth their consumption over their lifetime, despite fluctuations in their income from youth through retirement.

According to the Life-Cycle Hypothesis graph, when in life do individuals typically borrow (dissave)?

Individuals typically borrow early in life (e.g., as students) when their income is below their desired consumption level.

According to the Life-Cycle Hypothesis graph, when in life do individuals typically save?

Individuals typically save during their prime working years when their income is highest and exceeds their consumption level.

Concept: Permanent Income ($Y^P$)

Definition: The constant flow of income that would deliver the same present value of wealth as the actual, fluctuating expected income path an individual faces.

The Life-Cycle and Permanent Income hypotheses state that consumption is a function of , while John Maynard Keynes argued it is a function of .

wealth ($\Omega$); disposable income ($Y^d$)

Empirically, the link between consumption and appears tighter than the link between consumption and .

disposable income; wealth

What are three reasons cited for why the empirical link between consumption and disposable income is stronger than the link with wealth?

1. Wealth is difficult to measure accurately. 2. Wealth is more volatile than income (e.g., stock prices). 3. The presence of credit constraints.

How do credit constraints prevent individuals from achieving their optimal consumption plan?

Credit constraints prevent individuals from borrowing against future income, forcing their current consumption to be limited by their current income, even if they expect higher income later.

When do credit constraints primarily affect a household's consumption decision?

They apply primarily when a household would be better off by borrowing (their optimal consumption point is to the right of their current income endowment) but are unable to do so.

The modern consumption function incorporates both Keynesian and life-cycle views. What is its general form?

The consumption function is expressed as $C = C(\Omega, Y^d)$, indicating that consumption depends positively on both wealth ($\Omega$) and disposable income ($Y^d$).

Why is the effect of a change in the real interest rate ($r$) on consumption considered ambiguous?

The effect is ambiguous because an increase in 'r' benefits net lenders (positive income effect) but hurts net borrowers, leading to different consumption responses.

In macroeconomics, investment (I) is also known as _.

gross domestic capital formation

Why is a firm's investment decision considered an intertemporal decision?

It involves a trade-off between using resources for consumption today versus investing in capital goods to enable the production of more goods and services for future consumption.

What is the fundamental rule for a firm to determine its optimal amount of capital stock ($K$)?

The firm chooses the capital stock where the marginal product of capital equals its marginal cost, expressed as $MPK = 1+r$.

In the profit function $\pi = F(K) - (1+r)K$, what does the term $(1+r)K$ represent?

It represents the total cost of capital, where 'r' is the real interest rate (either the cost of borrowing or the opportunity cost of using owned funds).

If a firm's current capital stock is at a level where $MPK > 1+r$, what should the firm do?

The firm should increase its investment in capital because the return from an additional unit of capital exceeds its cost.

How does technological progress typically affect a firm's desired capital stock?

Technological progress increases the marginal product of capital (MPK), shifting the MPK curve up and leading to a higher desired capital stock.

How does an increase in the real interest rate ($r$) affect a firm's desired capital stock?

An increase in the real interest rate raises the marginal cost of capital, leading to a lower desired capital stock.

The optimal capital stock depends positively on the level of technology and negatively on the _.

real interest rate (r)

Once a firm's capital stock is at its desired level, what is the purpose of ongoing investment?

Ongoing investment serves to replace capital that has depreciated.

Concept: Tobin's q (or q theory of investment)

An investment theory where a firm's investment decisions are a function of its stock market valuation relative to the replacement cost of its physical capital.

What is the formula for Tobin's q?

$q = \frac{\text{Market value of the firm's capital}}{\text{Replacement cost of the firm's capital}}$

According to Tobin's q theory, what is the investment incentive for a firm when $q > 1$?

When $q > 1$, the market values installed capital at more than its replacement cost, creating a strong incentive for the firm to invest in new capital.

According to Tobin's q theory, what is the incentive for a firm when $q < 1$?

When $q < 1$, the market values installed capital at less than its replacement cost, creating an incentive for the firm to disinvest (sell off capital) or for others to acquire the firm.

What are two reasons why a firm's market value might differ from the replacement cost of its physical capital?

The existence of intangible assets (like reputation and know-how) and demand fluctuations in stock markets (booms and busts).

How does a higher real interest rate ($r$) affect a firm's valuation and investment according to the Tobin's q framework?

Higher interest rates reduce the present discounted value of future profits, which depresses the firm's market valuation (lowers q) and thus reduces investment.

How can a stock market boom, independent of a firm's fundamentals, affect investment?

A stock market boom can increase a firm's market value ($Q$), raising its Tobin's q and thereby encouraging more investment, even without a change in expected profits.

Why does the forward-looking nature of Tobin's q help explain the high volatility of investment?

Because Tobin's q is based on expectations about the future, which can change quickly and dramatically, it leads to high volatility in investment spending.

The modern investment function states that investment is a function of which two key variables?

Investment is a function of Tobin's q ($q$) and the real interest rate ($r$), written as $I = I(q, r)$.

In the investment function $I = I(q, r)$, what is the relationship between investment and Tobin's q, and between investment and the real interest rate?

Investment is positively related to Tobin's q ($q$) and negatively related to the real interest rate ($r$).