How do people decide how much to consume and how much to save? Until now. we have assumed that consumption and saving depended only on current income. I5y now, you realise they depend on much more, particularly on expectations ol the future. We now explore how those expectations affect the consumption decision.
Thc theory of consumption on which this section is based was developed independently in the 1950s by Milton Friedman, of the University ol Chicago, who called it the permanent income theory of consumption, and by Franco Modigliani, ol thc Massachusetts Institute ol Technology, who called it the life cycle theory of consumption Each chose his label carefully. Friedman's permanent income' emphasised that consumers look beyond current income. Modigliani's lile cycle emphasised that consumers' natural planning horizon is their entire lifetime.
The behaviour ol aggregate consumption has remained a hot area ol research ever since, tor three reasons. One is simply thc sheer size ol consumption as a component ot CDP. and therefore the need to understand movements in consumption. The second is the increasing availability ol large surveys ol individual consumers, such as the PSID in the United States, and HILDA in Australia. Also, the quality ot data across thc different states within countries has improved significantly, allowing economists to get answers to otherwise impossible questions. Issues relating to the PSID and state panels are described in the focus box Lip close and personal: learning from panel datasets . These surveys, which weren't available when Friedman and Modigliani developed their theories, have allowed economists to steadily improve their understanding of how consumers actually behave. This section summarises what wc know today.
Panel datasets are datasets that give the value of one or more variables for many individuals or many firms, or even many states in a country, over time. We described one such Australian survey, the Labour Force Survey (or LFS), in Chapter 6. Other examples of a household-level survey are the US Panel Study of Income Dynamics, or PSID (you can find out more about PSID at
The PSID
The PSID is a microeconometric dataset that was started in 1968 with approximately 4,800 families. Interviews of these families have been conducted every year since, and are still continuing.The survey has grown as new individuals have joined the original families, either by marriage or by birth. Each year, the survey asks people about their income, wage rate, number of hours worked, health, and food consumption. (The focus on food consumption is because one of the surveys initial aims was to better understand the living conditions of poor families.The survey would be more useful if it asked about all of consumption rather than food consumption. Unfortunately, it does not.)
By giving forty years of information about individuals and about extended families, the survey has allowed economists to ask and answer questions for which there was previously only anecdotal evidence. Among the many questions that the PSID has been used to answer are:
• How much does (food) consumption respond to transitory movements in income—for example, to the loss of income from becoming unemployed?
• How much risk sharing is there within families? For example, when a family member becomes sick or unemployed, how much help does she get from other family members?
• How much do people care about staying geographically close to their families? When somebody becomes unemployed, for example, to what extent does the probability that he will migrate to another city depend on how many family members live in the city in which he currently lives?
HILDA
The HILDA Survey is conducted every year and the datasets provide valuable detail at the household level about income, the labour market and family dynamics in Australia. It is funded by the Commonwealth government of Australia. The first wave was conducted in 2001-02 and the sixth wave became available in January 2008.The survey covers almost 20,000 people who are tracked over time. It is a new resource for Australian researchers, and, although the panel is not very long in years, it is already yielding fascinating information about the Australian economy. For example:
Higher unemployment and job insecurity lead to more mental health problems. Healthier people save proportionately more, and are richer.
Urban households have a larger share of their wealth in housing, suggesting that housing is more expensive in cities.
A higher level of education leads to greater wealth, by affecting labour-market outcomes. People who work very long hours (50 or more per week) do so because of'consumerism': that is, they get into a 'work and spend cycle'.
State panel datasets
BOX
UP CLOSE AND PERSONAL: LE
** a*
Macroeconomists are becoming increasingly interested in panel datasets across states in a country. For example, in the first section of the chapter, we are interested in seeing whether wealth can impact on consumption.Two important components of wealth are housing wealth and stock-market wealth. While there is plenty of evidence proving that total wealth affects consumption (with a marginal propensity in Australia of about 4-5 cents per dollar of wealth), we would expect the housing and stock-market components of wealth to have different effects.This is largely because housing wealth is much less liquid and is held by all classes (not
just the better-off). Since housing and share price movements are correlated at the national level, it is almost impossible to disentangle their effects with national data. But if we use panels across states of the country, we find that individual state housing prices are much less correlated with stock prices (which are national in character), which means we can disentangle their effects. Using this insight, Nikola Dvornak and Marion Kohler of the RBA have shown that stock-market wealth raises medium-run consumption in Australia by up to 9 cents per dollar, while housing wealth has only a 3 cents effect. (See RBA, RDP, 2003-07,
The very foresighted consumer
Let's start with an assumption that will surely—and rightly—strike you as extreme, bur will serve as a convenient benchmark. We'll call it the theory of thc very foresighted consumer. How would a very loresighted consumer decide how much to consumer He would proceed in two steps:
• first, he would add up the value ol the stocks and bonds he owns, the value ol his cheque and savings accounts, the value ol the house he owns minus the mortgage still due, and so on. I bis would give him a notion of his financial wealth and his housing wealth.
He would also estimate what his alter-tax labour income was likely to be over his working lite and calculate the present value of expected alter-tax labour income. This would give him an estimate ol what economists call his human wealth—to contrast it with his non-human wealth, defined as the sum ol linanciai wealth and housing wealth.
(16.1)
• Adding his human wealth and non-human wealth, he would have an estimate of his total wealth. He would then decide how much to spend out ol this total wealth. A reasonable assumption is that he would decide to spend a proportion of total wealth to maintain roughly the same level of consumption each year throughout his life. II that level ol consumption was higher than his current income, he would then borrow the difference. If it were lower than his current income, he would instead save the difference.
Let's write this formally. What we have described is a consumption decision ol the form
With a slight abuse of language, we will use 'housing wealth' to refer у not only to housing but also to the other goods that the consumer may own, from cars to paintings. and so on.
Human wealth + ► non-human wealth = Total wealth.
С, = О Total wealth,)
where С is consumption at time f, and total wealth, is the sum of non-human wealth (financial plus housing wealth) and human wealth at time f (the expected present value, as of time I, ol current and luture arter-tax labour income).
This description contains much tnith. Like thc foresighted consumer, wc surely do think about our wealth and our expected future labour income in deciding how much to consume today. But one cannot help thinking that it assumes too much calculation and foresight on thc part of the typical consumer.
To get a better sense ol what that description implies and what is wrong with it, let's apply this decision process to the problem facing a typical university student.
An example
Let's assume you arc twenty-one years old, with three more years of university before you start your first job. You may be in debt today, having borrowed to go to university. You may own a car and a few other worldly possessions. For simplicity, let's assume your debt and your possessions roughly offset each other, so that your non-human wealth is equal to zero. Your only wealth, therefore, is your human wealth, the present value of your expected after-tax labour income.
You expect your starting annual salary in three years to be around $40,000 (in year 2008 dollars) and to increase by an average of 3 per cent a year in real terms, until your retirement at age sixty. About 25 per cent ot your income will go to taxes.
Because each of us is ► a consumer, we can use introspection as a way of checking the plausibility of a particular theory.
You are welcome to ^ use your own numbers, and see where the calculation takes you.
Building on what you saw in Chaptcr 14, let's calculate the present value of your labour income as the value of real expected after-tax labour income discounted using real interest rates (equation [ 14.7 ).
Let Yj , denote real labour income in year t. Let T. denote real taxes in year I.
Let V( Y'j, - Vj) denote your human wealth—that is. the expected present value of your after-tax labour income expected ES of year t.
To make the calculation simple, assume that the real interest rate equals zero—so the expected present value is simply the sum ot expected labour income over your working life and is therefore given by
V(Yi,-Ti) = ($40,000)(0.75)[ I + (1.03) + (1.03)2 + ... + (1.03)*]
The lirst term ($40,000) is your initial level ol labour income in year 2008 dollars.
The second term 0.75 comes from the lact that, because of taxes, you keep only 75 per cent of what you earn.
The third term [I + • 1.03) + (I.03)2 t ... + (|.03)36] reflects the fact that you expect your real income to increase at 3 per cent a year for thirty-seven years. (You will start earning income at age twenty-four and work until age sixty.)
Llsing the properties of geometric scries to solve lor the sum in brackets gives:
V(Yl, - T;) 0.75 (66.2)($40,000) = $1,986,000
Your wealth today, the expected value ol your lifetime after-tax labour income, is around $2 million. And you didn't think you were a millionaire?
How much should you consumer You can expect to live about sixteen years after retirement, so that your expected remaining life today N lifty-six years. II you want to consume the same amount every year, the constant level of consumption that you can afford equals your total wealth divided by your cxpectcd remaining life, or $ 1.986.000 56 $35,464 a year. Given that your income until you get your lirst job is equal to zero, th s implies borrowing $35,464 a year (or the next three years, and starting to save when you get your lirst job.
Towards a more realistic description
Your lirst reaction to this calculation may be that this is a stark and slightly sinister way of summarising your lite prospects. Your second reaction may be that while you agree with most of the ingredients that went into the calculation, you surely don t intend to borrow $35,464 X 3 - $ 106,392 over the next three years.
1. You may not want to plan for constant consumption over your lifetime and may be quite happy with deferring higher consumption until later. Student lite usually doesn't leave much time tor expensive activities. You may want to defer buying a luxury car and taking diving trips to the Galapagos Islands to later in lilc. You also have to think about the additional expenses that will come with having children, sending them to school, on holidays, to university, and so on.
2. You may lind that the amount of calculation and loresight involved in the calculation lar exceeds the amount you use in your own decisions. You may never have thought until now about exactly how much income you arc going to make, and for how many years. You may feel that most consumption decisions arc made in a simpler, less forward-looking fashion.
3. Ihe calculation of total wealth is based on forecasts ot what can reasonably be expected to happen. But things can turn out better or worse. What happens if you are unlucky and you become unemployed or sick? How will you pay back what you borrowed? You may well want to be prudent, to make sure that you can adequately survive even the worst outcomes, and thus borrow much less than $106,392.
4 The calculation of the consumption level you an sustain is made easier by our assumption that the real interest rate equals zero. In this case, if you consume one fewer good today, you can consume exacdy one more good next year, and the condition you must satisfy is simply that the sum of consumption over your lifetime is equal to your wealth. So, if you want to consume a constant amount each year, you just need to divide your wealth by the remaining number of years in your life.
4. F.ven if you decided to borrow $106,392, you are likely to find the bank from which you try to borrow that amount to be unreceptive. Why? The hank may worry that you are taking on a commit¬ment you won't be able to afford if times turn bad. and that you may not be able or willing to repay the loan.
These reasons, all good ones, imply that to characterise consumers' actual behaviour we must modify lhe description we gave earlier. The last three reasons, in particular, suggest thai consumption depends not only on total wealth hut also on currcnt income.
Take the second reason. You may because it is a simple rule, decide lo let your consumption follow your income and not think about what your wealth might be. In that case consumption will depend on current income, not on your wealth.
Now take the third reason. It implies that a safe rule may be to consume no more than your current income. This way. you don't run the risk ol accumulating debt lhat you couldn't repay ii times were to turn bad
Or take the fourth reason. It implies that you may have little choice anyway. Hvcn il you wanted to consume more than your current income, you may be unable to do so, since no bank will give you a loan.
II we want to allow for a direct effect ol current income on consumption what measure ol current income should we use? A convenient variable is after-tax labour income, introduced earlier in defining human wealth. I his leads to a consumption function of the form
C. = C(Total wealth,,Yu - T,) (16.2)
In words: Consumption is an increasing function of total wealth, and also an increasing function of current after-tax labour income. Total wealth is the sum of non-human wealth—financial wealth plus housing wealth—and of human wealth—the present value of expected after-tax labour income.
How expectations of higher output in the *
future affect consumption today: Expected future output " leads to Expected future labour income leads to Human wealth leads to Consumption today . Expected future income I leads to Expected future dividends t leads to Stock prices T leads to Non-human wealth t leads to Consumption today T.
How much does consumption depend on total wealth and thus on expectations ol luture income! and how much on current income? The evidence is that most consumers look forward, in the spirit ol Modigliani and Friedman. See the focus box Do people save enough lor retirement?'. But some consumers especially those who have a temporarily low income and poor access to credit, are likely to consume their current income regardless ol what they expect will happen to them in the future. A worker who becomes unemployed and has no linanciai wealth may have a hard time borrowing to maintain her level ol consumption, even if she is tairlv confident that she will soon find another job. Consumers who are richer and have easier access to credit are more likely lo give more weight to the future and to try to maintain roughly constant consumption over time.
Putting things together: Current income, expectations and consumption
I.els go hack lo what motivates this chapter—the importance ol expectations in lhe determination of spending. Note first lhat, with consumption behaviour described by equation ■ 16.2 i. expectations allcct consumption in two ways:
• Expectations affect consumption directly through human wealth. To calculate their human wealth, consumers have lo form their own expectations ol luture labour income, real interest rates and
taxes.
• Expectations affect consumption indirectly, through non-human wealth—stocks, bonds, housing. Consumers don't need to do any calculation here and can take the value of these assets as given. But. as you saw in Chapter 15, ihe calculation is in effect done lor them hy financial markets. The price of their stocks, for example depends itself on expectations ol future dividends and interest rales.
This dependence of consumption on expectations has in turn two main implications lor the relation between consumption and income:
• Consumption is likely to respond less than one-for-one to fluctuations in current income. In deciding how much to consume, consumers look at more than current income. II ihey conclude that a decrease in income is permanent, they may decrease consumption one-for-one with the decrease in income. But if they conclude thai the decrease in current income is transitory, ihev will adjust their consumption by less. In a recession, consumption adjusts less than one-lor-one to decreases in income. This is because consumers know that recessions typically don t last for more than a lew
DO PEOPLE SAVE ENOUGH FOR RETIREMENT?
How carefully do people look forward when making consumption and saving decisions? One way to answer this question is to look at how much people save for retirement.
Table I, taken from a study by Steven Venti, from Dartmouth, and David Wise, from Harvard, based on a panel dataset called the Survey of Income and Program Participation gives the basic numbers for the United States.The table shows the mean level and the composition of (total) wealth for people 65-69 years in 1991 — so, most of them were retired.
The first three components of wealth capture the various sources of retirement income. The first is the present value of social security benefits. The second is the value of the retirement plans provided by employers. And the third is the value of personal retirement plans. The last three components include the other assets held by consumers, such as bonds and stocks, and housing.
A mean wealth of $314.000 is substantial (for comparison, US per capita personal consumption at the time of the study [ 1991 ] was $ 16,000). It gives an image of forward-looking individuals making careful saving decisions and retiring with enough wealth to enjoy a comfortable retirement.
We must be careful, however. The high average may hide important differences across individuals. Some individuals may save a lot, others little.
Another study, by Scholz, Seshadri and Khitatrakun, from the University of Wisconsin, sheds light on that aspect, again for the United States. The study is based on another panel dataset. called the Health and Retirement Study.The panel consists of 7,000 households whose heads of household were 51-61 years of age at the time of the first interview in 1992, and who have been interviewed every two years since then. The panel contains information about the level and the composition of wealth for each household, as well as its labour income (if the individuals in the household have not yet retired). Based on this information, the authors construct a target level of wealth for each household—that is, the wealth level that each household should have if it wants to maintain a roughly constant level of consumption after retirement. The authors then compare the actual wealth level to the target level, for each household.
The first conclusion of their study is similar to the conclusion reached by Venti and Wise. On average, people save enough for retirement. More specifically, the authors found that more than 80 per cent of households have wealth above the target level. Put the other way around, only 20 per cent of households have wealth below the target. But these numbers hide important differences across income levels.
Among those in the top half of the income distribution, more than 90 per cent have wealth that exceeds the target, often by a large amount. This suggests that these households plan to leave bequests, and so save more than what is needed for retirement.
FOCUS BOX
Among those in the bottom 20 per cent of the income distribution, however, less than 70 per cent have wealth above the target. For the 30 per cent of households below the target, the difference between actual
Table 1 Mean wealth of people, aged 65-69, in 1991 (in thousands of 1991 dollars)
Social security pension $100
Employer-provided pension 62
Personal retirement assets 11
Other financial assets 42
Home equity 65
Other equity 34
Total $314
SOURCE. Vent; and Wise.Table AI.
and target wealth is typically small. But the relatively large proportion of individuals with wealth below the target suggests that there are a number of individuals who, through bad planning or bad luck, do not save enough for retirement For most of these individuals, nearly all their wealth comes from the present value of social security benefits (the first component of wealth in Table I), and it is reasonable to think that the proportion of people with wealth below target would be even larger if social security did not exist. This is indeed what the US social security system was designed to do: to make sure that people have enough to live on when they retire. In that regard, it appears to be a success.
Go back to the two ► consumption functions we used in The Core. Looking at the short run (Chapter 3). we assumed С = Сц + С) У (ignoring taxes here). This implied that, when income increased, consumption increased less than proportionately with income (OY went down).This was appropriate, as our focus was on fluctuations, on transitory movements in income. Looking at the long run (Chapter 10). we assumed S = sY, or. equivalently. С = (1 - s)Y. This implied that, when income increased, consumption increased proportionately (OY remained the same). This was appropriate, as our focus was on permanent—long-run— movements in income.
SOURCES: Steven Venti and David Wise. 'The wealth of cohorts: retirement and saving and the changing assets of older Americans'. NBER Working Paper. 1996: John Scholz.Ananth Seshadri and Surachai Khitatrakun,'Are Americans saving "optimally" for retirement?'. NBER Working Paper. 2004.
quarters, and that the economy will eventually return to the natural level of output. The same is usually ime in expansions. Faced with an unusually rapid increase in income, consumers are unlikely to increase consumption by as much as income. They are likely to assume that the boom is transitory, and that things will return to normal. • Consumption may move even if current income doesn't change. The election of a charismatic prime minister who articulates the vision ol an exciting luture may lead people to become more optimistic about the future in general, and about their own luture income in particular, leading them to increase consumption even il their current incomc doesn't change. The Australian recession in 1990-91 was caused by tight policy but may well have been amplified by a decrease in consumption, caused in turn by a decrease in consumer confidence. Consumer pessimism can easily be one of the main causes of a recession.
One of the main worries macroeconomists had alter the events ol 11 September 2001 was that consumers would become pessimistic and consumption would drop, leading to a deeper recession. As you saw in Chapter 3, this wasn't the case. While consumer confidence fell in the months lollowing 11 September 2001, the fall was much smaller than was feared and did not derail the recovery.
16.2 INVESTMENT
How do lirms make investment decisions? In our first pass at the answer in The Core (Chapter 5), we took investment to depend on the current interest rate and the current level of sales. We improved on that answer in Chaptcr 14 by pointing out that what mattered was the real interest rate, not the nominal interest rale. It should now be clear that investment decisions, just as consumption decisions, depend on more than the current real interest rate and current sales. They also depend very much on expecta¬tions of the future. We now explore how those expectations affect investment decisions.
lust like the basic theory ol consumption, the basic theory ol investment is straightforward. A lirm deciding whether to invest—say, whether to buy a new machine—must make a simple comparison. The lirm must first calculate the present value of profits it can expect from having this machine. It must then comparc the present value ol profits with the cost of buying the machine. II the present value exceeds the cost, the firm should buy the machine—invest, if the present value is less than the cost, the firm shouldn't buy the machine—not invest. This, in a nutshell, is the theory of investment. Let's look at it in more detail.
Investment and expectations of profit
Let's go through the steps a lirm must take to determine whether to buy a new machine. (While we refer to a machine, the same reasoning applies to the other components ol investment—the building ol a new factory, the renovation of an office complex, and so on.i
Depreciation
To calculate the present value of expected profits, thc lirm must first estimate how long the machine will last. Most machines are like cars. They can last nearly forever, but as time passes thev become more and more expensive to maintain, and less and less reliable.
Assume that a machine loses its usefulness at rate S (the Greek lowercase delta) per year. A machine that is new this year is worth only (1-5) machines next year 1-й)2 machines in two years, and so on. The depreciation rate. <5. measures how much usefulness thc machine loses from one year to thc next. What are reasonable values for 6? This is a question lhat the statisticians in charge of calculating how a country's capital stock changes over time have had to answer. Based on their studies of depreciation of specific machines and buildings, they use numbers between 4 per cent and 15 per cent lor machines, and between 2 per ceni and I per cent lor buildings and factories.
Thc present value of expected profits
The lirm must then calculate the present value of expected profits.
« If the firm has a large number of machines, we can think of Л as the proportion of machines that die every year. (Think of light bulbs— which work perfectly until they die.) If the firm starts the year with К working machines and doesn't buy new ones, it has only К(1 - в) machines left one year later, and so on.
To capture the fact thai it takes some time to put machines in placc and even more time to build a factory or an office building), lei's assume thai a machine bought in year t becomes operational—and starts depreciating—only one year later, in year t + I. Denote prolit per machine in real terms by П. (This is an uppercase Greek pi, as opposed to thc lowercase Greek pi, which we use to denote inllation.1
1
If the firm buys a machine in year f, the machine generates its first expected profit in year f + 1. denote this expected profit by П;'_,. The present value, in year t, of this expected profit in year I -r I, is given by
-n?+I
This term is represented by the arrow pointing lelt in thc upper line ot Figure 16.1. Because we arc measuring profit in real terms, we are using real interest rates to discount future profits. This is one of thc lessons wc learned in Chapter 14.
(1 - 6)ITN2
Denote expected profit per machine in year t + 2 by П;'.2. Because ol depreciation, only ; I - Й) of the machine bought in year t is lelt in year t ■ 2, so the expected prolit from thc machine is equal to 1 - 6)П'+2. The present value ot this expected prolit as ot year I is equal to
(i + r,)(i + г;'.,)
This calculation is represented by the arrow pointing lelt in thc lower line ot Figure 16.1. The same reasoning applies to expected profit in following years. Putting thc pieces together gives us thc present value of expected profits from buying the machine in year t—call it Vi IT,'):
(i - S)n';,2 +
V'ILT;)
IК
1 l! I
(16.3)
1 + r
(1 + r,)(1 + rf4l)
The expected present value is equal to the discounted value ol expected profit next year plus the discounted value of expected prolit two years from now (taking into account the depreciation of the machine1 and so on.
Figure 16.1 Calculating the present value of expected profits
Expected profit in: Year t + 1 Year t + 2
1С,
1
(1-6)I1?+J
(1 -Й)П%2
(1 +rt)(1 +'t+i)
The investment decision
The lirm must then decide whether to buy the machine This decision depends on the relation between the present value ol expected profits and the price of the machine. To simplily notation, let s assume the real price ol a machine—that is, the machine's price in terms ol the basket of goods produced in the economy—equals I. What the firm must then do is compare the present value ol profits with I.
It the present value is less than I, the firm shouldn't buy the machine. It it did. it would be paying more lor the machine than it expects to get back in profits later. II the present value exceeds I. the lirm has an incentive lo buy the new machine.
Lets now go Irom this one-firm, one-machine example to investment in the economy as a whole.
Let If denote aggregate investment.
Denote profit per machine, or, more generally, prolit per unit ot capital (where capital includes machines, lactones, office buildings, and so on . lor ihe economy as a whole by 11,.
Denote the expected present value ot prolit per unit ot capital by V(11', defined as in equation 16.3).
Our discussion suggests an investment function of the form:
/, - J(V
In words: Investment depends positively on the expected present value of future profits (per unit of capital). The higher the current or expected profits, the higher the expected present value and the higher the level of investment. The higher the current or expected real interest rates, the lower the cxpectcd present value, and thus the lower the level of investment.
II the present value calculation the lirm has to make strikes you as quite similar to the present value calculation we saw in Chapter 15 lor the fundamental value of a stock, you are right. This relation was Tobin received :he ''rsl explored by James Tobin, from Yale University, who argued that there should indeed be a light Nobel Prize in relation between investment and the value ol the stock market. His argument and the evidence arc- economics in 1981. ► presented in the focus box 'Investment and ihe stock market'
FOCUS INVESTMENT AND THE STOCK MARKET
Suppose a firm has 100 machines and 100 shares outstanding—one share per machine. Suppose the price per share is $2. and the purchase price of a machine is only $1. Obviously, the firm should invest—buy a new machine and finance it by issuing a share. Each machine costs the firm $1 to purchase, but stock-market participants are willing to pay $2 for a share corresponding to this machine when it is installed in the firm.
This is an example of a more general argument made by James Tobin that there should be a tight relation between the stock market and investment. In deciding whether to invest, he argued, firms may not need to go through the type of complicated calculation you saw in the text. In effect, the stock price tells firms how much the stock market values each unit of capital already in place. The firm then has a simple problem: compare the purchase price of an additional unit of capital with the price the stock market is willing to pay for it. If the stock-market value exceeds the purchase price, the firm should buy the machine: otherwise, it should not.
Tobin then constructed a variable corresponding to the value of a unit of capital in place relative to its purchase price, and looked at how closely it moved with investment. He used the symbol 'q' to denote the variable, and the variable has become known as Tobin's q. Its construction is as follows. I. Take the total value of Australian corporations, as assessed by financial markets. That is, calculate the sum of their stock-market value (the price of a share times the number of shares). Calculate also the total value of their bonds outstanding (firms finance themselves not only through stocks but also through bonds). Add together the value of stocks and bonds.
2. Divide this total value by the value of the capital stock of Australian corporations at replacement cost
(the price firms would have to pay to replace their machines, their plants, and so on).
The ratio gives us. in effect, the value of a unit of capital in place relative to its current purchase price.This ratio isTobin's q. Intuitively, the higher q is, the higher the value of capital relative to its current purchase price, and the higher should be investment. (In the example at the beginning of this discussion,Tobin's q is equal to 2: the firm should definitely invest.)
How tight is the relation between Tobin's q and investment? The answer is given in Figure I, which plots the rate of change of the two variables for each year from 1971 to 2007 for Australia, with the Tobin's q variable lagged by one year. Take 1987, for example: the figure shows the rate of change of investment to capital for 1987, and the rate of change of Tobin's q for 1986—that is, a year earlier.The reason for presenting the two variables in this way is that the strongest relation in the data appears to be between investment this year and Tobin's q last year. Put another way, movements in investment are more closely associated with movements in the stock market last year than with movements this year: this may be because it takes time for firms to make investment decisions, build new factories, and so on.
The message from the figure is clear: there is a strong relation between Tobin's q and investment. This is probably not because firms follow blindly the signals from the stock market but because investment decisions and stock-market prices depend very much on the same factors—expected future profits and expected future interest rates.
30 n
-30
i i i i i i i
1970 1975 1980 1985
I I I I I I I I I I I I I I I I I
1990 1995 2000 2005
Rate of change of the
ratio of investment to I Rate of change of
capital I I Tobin's q
I Л м (lagged one year)
Figure I Tobin's q versus the ratio of investment to capital—annual rates of change. Australia, 1971-2007
The shaded columns represent recession periods. There is a significant positive statistical relationship between investment growth and lagged q growth. SOURCES: ABS. cat. no. 1364.Tables 23.24. 36.
A convenient special case
Before exploring further implications and extensions ol equation (16.4 1 it is useful to go through a special case where the relation between investment, profit and interest rates becomes very simple.
Suppose firms expect both luture profits (per unit of capital) and future interest rates to remain at the same level as today, so that
П,
IK
ПГ.2
and
rf.,
= r.
Г?,2
Economists call such expectations (in which people expect the future to be like the present static expectations. Under these two assumptions, equation (16.3) becomes
(16.5)
nf
vin-;) =
r, +
The derivation is given in the appendix to this chapter.)
The present value ol expected profits is simply the ratio of the profit rale—that is, profit per unit ol capital—to the sum of the real interest rate and the depreciation rate.
Replacing 16.5 > in equation (16.4), investment is
П,
I6.61
r, + S
I, = I
Investment is a function of the ratio of the prolit rate to the sum of the interest rate and the depreciation rate. Look more closely at the expression in parentheses. The denominator—the sum of the real interest rate and the depreciation rate—is called the user cost or the rental cost of capital To see why it is callcd the rental cost ol capital, suppose that the firm, instead of buying the machine, rented it by the year from a rental agency. How much would the rental agency have to charge? Even if the machine didn't depreciate the agency would have to charge an interest rate iits opportunity cost) equal to r, times the pricc of the machine. Wc have assumed the price of a machinc to be I in real terms, so r. times I is iust r,. The agency has to get at least as much from buying and then renting the machine as it would Irom, say, buying bonds. In addition, the rental agency would have to charge for depreciation, й times the price of the machine, I. Therefore,
Rental cost = (rf + 5)
Even though firms typically don't rent their machines, (r, + 5i still captures the implicit cost— sometimes callcd the shadow cost—to the firm ot using the machine for one year.
The investment function given by equation (16.6) then has a simple interpretation: Investment depends on the ratio of profit to the user cost. The higher the profit rate, the higher the level of investment. The higher the real interest rate, the higher the user cost, the lower the level of investment.
This relation between profit, the real interest rate and investment relies on a strong assumption: that the future is cxpected to be the same as the present. It is nevertheless a useful relation to remember, and a relation macrocconomists keep handy in their toolbox.
Current versus expected profit
Such arrangements exist: ► many Arms lease cars, trucks and even computers from leasing companies.
If the future is expected t to be the same as the present, investment depends on the ratio of profit to the user cost— the sum of the real interest rate and the depreciation rate.
The theory we have developed so far implies that investment should be forward looking and depends primarily on expected future profits. (Under our assumption that new capital starts being operational only one year after purchase, current profit doesn't even appear in equation [16.3].! One striking empirical tact about investment, however, is how strongly it moves with fluctuations in current profit lagged one year.
This relation is shown in Figure 16.2 which plots yearly changes in investment and in lagged prolit since 1970 for thc Australian economy. Investment is measured as the ratio ol fixed private business 4 For definitions of all investment to the fixed business capital stock. Thc profit measure is constructed as the ratio of the a fter- these terms, see tax gross operating surplus of Australian businesses divided by their capital stock. The shaded areas in thc figure represent years in which there was a recession—a decline in output for at least two consecutive quarters of the year.
There is a clear positive relation between changes in investment and changes in current profit in Figure 16.2. Is this relation inconsistent with the theory we have just developed, which holds that investment should be related to the present value ol expected luture profits rather than to current profit? Not necessarily. If firms expect future prolits to move very much like current profit, then the present value ol prolits will move very much like current profit, and so will investment.
Economists who have looked at the question more closely have concluded, however, that the ellect of current profit on investment is stronger than would be predicted by the theory we have developed so lar. How they have gathered some ol the evidence is described in the focus box 'Profitability versus cash flow'. On the one hand, some firms with highly profitable investment projects but low current profits appear to be investing too little. On the other hand some firms that have high current profits appear sometimes to invest in projects of doubtful profitability. In short, current profit appears to affect investment, even after controlling lor the expected present value ol profits.
Why does current prolit play a role in the investment decision? The answer lurks in Section 16.1, where we discussed why consumption depends directly on current income. Some of the reasons we used to explain the behaviour of consumers also apply to firms.
• II its current profit is low, a firm lhat wants to buy new machines can gel lhe funds it needs only by borrowing. It may be reluctant to borrow. While expected prolits may look good, things may turn bad, leaving the firm unable to repay ihe debt. But if current profit is high, the firm may be able to linance its investment just by retaining some of its earnings and without having to borrow. The bottom line is lhat higher current profit may lead the firm to invest more.
Appendix I on National Income Accounts at the end of the book.
• Even if the firm wants to invest, it may have difficulty borrowing. Potential lenders may not be convinced the project is as good as the lirm says, and may worry that thc lirm will be unable to
Figure 16.2
Changes in investment and changes in profit in Australia, 1970-2008
0.3-1
0.2-
0.0
-0.3-
Change in investment to capital
Change in profit to capital (lagged 1 year)
м с rt X
о -0.1
91
a ac
-0.2
~0.4 -| i i i | | | I | | | | | | | | | | г~] I I I I I I П I I I I I I I I I I I I
1970 1975 1980 1985 1990 1995 2000 2005
The shaded columns represent recession periods. Investment and lagged profit move very much together. There is a significant positive statistical relationship between them.
SOURCES: ABS. OL no. 1364.Tables 23. 24: RBA.Tables G10. G11. G12
How much does investment depend on the expected present value of profits, and how much does it depend on current profit? In other words, what is more important for investment decisions: profitability (the expected present discounted value of profits), or cash flow (current profit, the net flow of cash the firm is receiving)?
The difficulty in answering this question is similar to the problem of identifying the relative importance of current income and expected future income on consumption—a problem discussed in the first focus box in this chapter. Most of the time, cash flow and profitability are likely to move together. Firms that do well typically have both large cash flows and good future prospects. Firms that suffer losses often also have poor future prospects.
As in the case for consumption, the best way to isolate the effects of cash flow and profitability is to identify times or events when cash flow and profitability move in different directions, and then look at what happens to investment. This is the approach taken by Owen Lamont, an economist at the University of Chicago. An example will help you to understand Lamont's strategy.
Think of two firms. A and B. Firm A is involved only in steel production. Firm В is composed of two parts, one part steel production, the other part oil exploration.
Suppose there is a sharp drop in the price of oil. leading to losses in oil exploration.This shock decreases firm B's cash flow. If the losses in oil exploration are large enough to offset the profits from steel production, firm В may show an overall loss.
The question we can now ask is: As a result of the decrease in the price of oil, will firm В invest less in its steel operation than firm A does? If only profitability in steel production matters, there is no reason for firm В to invest less in its steel operation than firm A. But if current cash flow also matters, the fact that firm В has a lower cash flow may prevent it from investing as much as firm A in its steel operation. Looking at investment in the steel operations of the two firms can tell us how much investment depends on cash flow versus profitability.
This is the empirical strategy followed by Lamont. He focuses on what happened in 1986 when the price of oil in the United States dropped by 50 per cent, leading to large losses in oil-related activities. He then looks at whether firms that had substantial oil activities cut investment in their non-oil activities relatively more than other firms in the same non-oil activities. He concludes that they did. He finds that for every $1 decrease in cash flow due to the decrease in the price of oil, investment spending in non-oil activities was reduced by 10 to 20 cents. In short: current cash flow matters.
SOURCES: Owen Lamont,'Cash flow and investment: evidence from internal capital markets'. Journal of Finance. March 1997. A general review of studies along these lines is given by R. Glenn Hubbard in 'Capital-market imperfections and investment'. Journal of Economic literature. 1998.
repay. Il the lirm lias large current prolits, it doesn't have to borrow and so doesn't need to convince potential lenders. It can procced and invest as it pleases, and is more likely to do so.
In summary: To fit the investment behaviour we observe, the investment equation is better written as
1, = /fV'(n?),n,| (16.7)
( + , + )
In words: Investment depends on both the expected present value of profits and the current level of profit.
Profit and sales
chaptcr 16
US PROFITABILITY VERSUS CASH FLOW
We have argued that investment depends on both current and expected profit. We must now ask: What determines profit? Answer: Primarily two lactors: 1 the level of sales, and (2) the existing capital stock. If sales are low relative to the capital stock, profits per unit of capital arc likely to be depressed as well.
Let's write this more formally. Ignore the distinction between sales and output, and let Y, denote output- —equivalently, sales. Let K, denote the capital stock at time f. Our discussion suggests the following relation:
(16.8)
Profit per unit of capital is an increasing function of the ratio ol sales to the capital stock, l or a given capital stock, the higher the sales, the higher the profit. For given sales, the higher the capital stock, the lower the prolit.
How does this relation hold in practice? Figure 16.3 plots yearly changes in profit per unit ol capital (measured on the right vertical axis) and changes in the ratio of output to capital (measured on the left vertical axisi, for Australia since 1970. As in Figure 16.2, profit per unit of capital is defined as thc sum of alter-tax gross operating surplus lor Australian corporations, divided by their capital stock, measured at replacement cost. The ratio of output to capital is constructed as thc ratio of GDP to the aggregate capital stock. The shaded areas are years during which the Australian economy was in recession.
The figure shows a lairly tight relation between changes in prolit and changes in the ratio of output to capital. Given that most of thc year-to-year changes in the ratio of output to capital come from movements in output (capital moves slowly over time,- even large swings in investment lead to slow changes in the capital stock , we can state the relation as follows: Profit decreases ill recessions and increases in expansions.
Why is this relation between output and prolit relevant here? Because it implies a link between current output and expected future output on the one hand and investment on the other: current output affects currcnt profit, expected future output affects expected future profit, and current and expected Mg(l expeae(j oucput future profits in turn affect investment. For example, the anticipation ol a long, sustained economic leads to high expected expansion leads lirms to expect high profits, now and for some time in the luture. These expectations profit leads to high in turn lead lo higher investment. The effect ol current and expected output on investment, together 4 investment today.
TO—i
(—20
Change in ratio of output to capital (scale at left)
-15
I I I I I I I I I I I I I I I I I I I I I I I I I I II I I I I I II I I I
1970 1975 1980 1985 1990 1995 2000 2005
Figure 16.3 Changes in profit and changes in the ratio of output to capital
in Australia. 1970-2008
The shaded columns represent recession periods. Profit and output move largely together in a significant statistical relationship. SOURCES: ABS. cat. no. 1364.Table 24: RBA. Tables G10. G11. G12.
EXPECTATIONS EXTENSIONS chapter 16
with the effect of investment back on demand and output, will play a crucial role when we return to the determination ot output in Chaptcr 17.
16.3 THE VOLATILITY OF CONSUMPTION AND INVESTMENT
You will surely have noticcd the similarities between our treatment of consumption and our treatment of investment behaviour in Sections 16.1 and 16.2:
• Whether consumers perceive current movements in income to be transitory or permanent affects their consumption decisions.
• In the same way, whether lirms perceive current movements in sales to be transitory or permanent affects their investment decisions. The less they expect a current increase in sales to last, the less they revise their assessment of the present value ol profits, and thus the less likely they are to buy new machines or build new factories. This is why, lor example, the boom in sales that happens every year in the fourth quarter leading up to Christmas doesn't lead to a boom in investment every year in December. Firms understand that this boom is transitory.
But there arc also important differences between consumption decisions and investment decisions:
• The theory of consumption we developed implies that, when faced with an increase in income consumers perceive as permanent, they respond with at most an equal increase in consumption. The permanent nature of the increase in income implies that they can afford to increase consumption now and in the future by the same amount as the increase in income. Increasing consumption more than one-for-onc would require cuts in consumption later, and there is no reason for consumers to want to plan consumption this way.
• Now consider the behaviour of firms faced with an increase in sales they believe to be permanent. The present value ol cxpectcd profits increases, leading to an increase in investment. In contrast to consumption, there is no implication that the increase in investment should be no greater than the increase in sales. Rather, once a firm has decided that an increase in sales justifies the purchase ol a new machine or the building ol a new lactory. it may want to proceed quickly, leading to a large but short-lived increase in investment spending. This increase may exceed the increase in sales. More concretely, take a firm that has a ratio of capital to its annual sales of, say, 3:1. An increase in
sales of $10 million this year, if expected to be permanent, requires the firm to spend $30 million on additional capital if it wants to maintain the same ratio of capital to output. It the lirm buys the additional capital right away, the increase in investment spending this year will equal three times the increase in sales. Once the capital stock has adjusted, the lirm will return to its normal pattern of investment. This example is extreme, because firms arc unlikely to adjust their capital stock right away. But even if they do adjust their capital stock more slowly, say over a lew years, the increase in investment may still exceed the increase in sales lor a while.
We can tell the same story in terms ot equation (16.8). As we make no distinction here between output and sales, the initial increase in sales leads to an equal increase in output, Y, so that Y/K—the ratio of the firm's output to its existing capital stock—also increases. The result is higher profit, which leads the firm to undertake more investment. Over time, the higher level of investment leads to a higher capital stock, K, so that Y/K decreases back to normal. Profit per unit of capital returns to normal, and so does investment. Thus, in response to a permanent increase in sales, investment may increase a lot initially and then return to normal over time.
These dilterences suggest that investment should be more volatile than consumption. How much more volatile? The answer from the data is given in Figure 16.4, which plots yearly rates ot change in Australian consumption and investment since I960.
The figure yields three conclusions:
• Consumption and investment usually move together. Recessions, for example, are typically associated with decreases in both investment and consumption. Given our discussion which has emphasised that consumption and investment depend largely on the same determinants, this shouldn't come as a surprise.
1 I I
1990
1995
I I I
2005
Figure 16.4 Rates of changes of real consumption and investment in Australia, 1960-2008
KEY TERMS
permanent income theory of consumption. 368 life cycle theory ol consumption, 368 panel datasets, 369 financial wealth. 370 housing wealth, 370 human wealth, 370 non-human wealth, 370 total wealth, 370 Tobin's q. 376 static expectations, 378 user cost of capital, rental cost of capital 378 profitability, 380 cash flow, 380
QUESTIONS AND PROBLEMS
Quick check
1. Using tin' information in this chapter, label each of the following statements 'true', 'false' or 'uncertain'. Explain briefly.
a. For the typical university student, human wealth and non-human wealth arc approximately equal.
b. Research on retirement doesn't suggest that expectations of future income arc a major lactor affecting consumption.
c. Buildings and factories depreciate much laster than machines do.
d. A high value lor Tobin's e. Economists have found that the ellect ol current profit on investment can be fully explained by the cflect ot current prolit on expectations of future prolits.
f. Data from the last three decades in Australia suggest that corporate profits arc closely lied lo the business cycle.
g. Changes in consumption and investment are typically in the same direction and roughly of the same magnitude.
2. A consumer has non-human wealth equal to ST00,001). She earns S40,000 this year, ami expects her salary to rise by 5 per ccnt in real terms each year for the following two years. She will then retire. The real interest rate is equal to 0 per cent and is expected to remain at 0 per cent in the future. Labour income is taxed at a rate of 25 per cent.
a. Whai is this consumer's human wealth?
b. What is her total wealth?
c. Il she expects to live for seven years alter retirement and wants her consumption to remain the same (in real terms) every year from now on, how much can she consume this year?
d. It she received a bonus of $20000 in ihe current year only, with all future salary payments remaining as stated earlier, by how much could she increase consumption now and in the future?
c. Suppose now thai, at retirement, her employer-sponsored superannuation fund will start paying benefits each year equal to 60 per cent ol her earnings during her lasi working year. (Assume thai benefits are not taxed.! How much can she consume this year and still maintain constant consumption)?
3. A pretzel manufacturer is considering buying another pretzel-making machine that costs $100,000. The machine will depreciate by S per cent per year. It will generate real profits equal to SIS,000 next year, SlS.OOOfl - 0.08) two years from now (that is, the same real profits, but adjusted for deprecia¬tion!, S18,000ll - 0.08)2 three years from now, and so on. Determine whether the manufacturer should buy the machine if the real interest rate is assumed to remain constant at
a. 5 per cent
b. 10 per cent
c. 15 percent
4. Suppose that, at age twenty-two, you have just finished university and have been offered a job with a starting salary of $40,000. Your salary will remain constant in real terms. However, you have also been admitted to a professional CPA accountancy program. The program takes two years to complete and upon graduation you expect your starting salary to be 10 per cent higher in real terms and to remain constant in real terms thereafter. Thc tax rate on labour income is 40 per cent.
a. If the real interest rale is zero and you expect lo retire at age sixty I that is, if you don t complete the professional program, you expect to work lor thirty-eight years in total), what is the maxi¬mum you should be willing to pay in tuition to attend this professional program?
b. What is your answer lo (a) il you expect lo pay 30 per cent in laxes?
Dig deeper
5. Individual saving and aggregate capital accumulation
Suppose that every consumer is born without any financial wealth ami lives for three periods: youth, middle age and retirement age. Consumers work in the first two periods and retire in the last one. Their income is $5 in the first period, $25 in the second, and $0 in the last one. Inflation and expected inflation are zero, and lhe real interest rate is also zero.
a. What is the present discounted value of future labour income ai the beginning ol lile? What is the highest sustainable level of consumption such that consumption is equal in all three periods?
b. For each age group, what is the amount ol saving that allows consumers to maintain the constant level ol consumption you lound in iai? Hint: Saving can be a negative number il the consumer needs lo borrow in order to maintain a certain level of consumption. >
c. Suppose there are people born each period. What is lotal saving? (Hint: Calculate the total amount saved by the generations that save and subtract the total amount dissaved by the generations that dissavc.) Explain.
d. What is total financial wealth in ihe economy? (Hint: Calculate lhe financial wealth of people at the beginning of the first period ol lile, the second period of life, the third period ol lile. [Remember that people can be in debt, so financial wealth can be negative.] Add them up.)
Suppose now that restrictions on borrowing don't allow young consumers to borrow. If we call the sum of income and total financial wealth 'cash on hand', then the borrowing restriction means that consumers cannot consume more than their cash on hand. In each age group, consumers compute their total wealth and then determine their desired level of consumption as the highest level thai allows their consumption to be equal in all three periods. However, if at any time, desired consumption exceeds cash on hand, then consumers are constrained to consume exactly their cash on hand.
e. Derive consumption in each period ol lile. Explain thc diflercncc between your answer here and your answer to (a).
I. Derive total saving. Explain the difference, il any, Irom your answer to (c).
g. Derive lotal financial wealth for the economy. Explain the difference Irom your answer to (d).
h. Consider the following statement: Financial liberalisation may be good for people, but it is bad tor overall capital accumulation Discuss.
6. Saving with uncertain future income
Consider a consumer who lives for three periods: youth, middle age and old age. When young, the consumer earns 520,000 in labour income. Turnings during middle age are uncertain: there is a 50 per cent chance that the consumer will earn $40,000 and a 50 per cent chance that the consumer will earn $100,000. When old, the consumer spends savings accumulated during the previous periods. Assume that inflation, expected inflation and the real interest rate equal zero. Ignore taxes for this problem.
a. What is the expected value ol earnings in the middle period of life? Given this number, what is the present discounted value ol expected lifetime labour earnings? II the consumer wishes to maintain constant cxpectcd consumption over her lifetime, how much will she consume in each period? How much will she save in each period?
b. Now suppose that the consumer wishes, above all else, to maintain a minimum consumption level of $20,000 in each period ol her life. To do so, she must consider the worst outcome. II earnings during middle age turn out to be $40,000, how much should the consumer spend when she is young to guarantee consumption of at least $20,000 in each period? How docs this level of consumption compare with the level you obtained for the young period in part (a)?
c. Given your answer in part (b), suppose that the consumer's earnings during middle age turn out to be $100,000, How much will she spend in each period of life? Will consumption be constant over the consumer's lifetime? (Hint: When the consumer reaches middle age, she will try to maintain constant consumption lor the last two periods ol lile. as long as she can consume at least $20,000 in each period.
d. What effect docs uncertainty about future labour incomc have on saving (or borrowing) by young consumers?
Explore further
7. The movements of consumption and investment
Go to the RBA website (www.rba.gov.au). Go to 'Statistics'. 'Bulletin Statistical Tables',' GVl'.
Download the quarterly data file, and then calculate annual data (that is, add up each of the quarters
for a particular year) for the years I960 lo the present for the following chain volume variables:
• real household consumption expenditures
• real gross private investment (total machinery and equipment)
• real gross domestic product.
a. On average, how much larger is consumption than investment?
b. Calculate the change in levels of consumption and investment from one year to the next, and graph them for the period I960 to the present. Are the year-to-year changes in consumption and investment of the same magnitude?
c. What do your answers in (a i and b) imply about the volatility of consumption and investment? Is this implication consistent with Figure 16.4? Calculate the standard deviation ol the consumption and investment changes as a measure of volatility. Which has the higher standard deviation?
d. Use Figure 16.4 to identify the years corresponding to the last two recessions. Using your graph from ib), which component played the largest role in each of these recessions, consumption or investment? Is this consistent with what we have learned so tar about these recessions?
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
APPENDIX: DERIVATION OFTHE EXPECTED PRESENTVALUE OF PROFITS UNDER STATIC EXPECTATIONS
You saw in the text that the expected present value of profits is given by
V(l-If) = UU ♦ {1 + ^ + (1 - ... (16.3)
If firms expect both future profits (per unit of capital) and future interest rates to remain at the same level as today, so that ll(+1 = IT,+2 = ... = II,,and г|ц = = ... = r,, equation (16.3) becomes
Factoring out [1/(1 + r()] П,.
1
(I6A.I)
(1-5)
The term in parentheses in this equation is a geometric series, a series of the form
1 + x + x2 + ... = 1/(1 - x)
(See proposition 2 in Appendix 2 at the end of the book.)
In equation (I6A.I) x equals (1 - S)/( 1 + rj.so the term in brackets on the right-hand side of (I6A.I) becomes
(1-5) (1 ~ 5)2 \ 1 1 + r,
1 + ,« . ч + ■ +
(1+0 (1+rJ2 - r _ 1-g rt + 5
1 + rt
Replacing this in equation (16A. I) gives
1 1 +r,
Simplifying gives equation (16.5) in the text:
V(n9 = — (.6.5)
CHAPTER ф
Expectations, Output and Policy
I
n Chapter 15 you saw how expectations affected bond and stock prices. In Chapter 16 you saw how expectations affected consumption decisions and investment decisions. In this chapter we put the pieces together and take another look at the effects of monetary and fiscal policy.
• Section I 7.1 draws the major implication of what we have learned—namely, that expectations of both future output and future interest rates affect current spending and therefore current output.
• Section 17.2 looks at monetary policy. It shows how the effects of monetary policy depend crucially on how expectations respond to policy. Monetary policy directly affects only the short-term interest rate.What happens to spending and output then depends on how changes in the short-term interest rate lead people and firms to change their expectations of future interest rates and future income and, by implication, lead them to change their spending.
• Section 17.3 turns to fiscal policy. It shows how. in sharp contrast to the simple model you saw back in The Core, a fiscal contraction may, under some circumstances, lead to an increase in output, even in the short run. Again, how expectations respond to policy is at the centre of the story.
17.1 EXPECTATIONS AND DECISIONS:TAKING STOCK
Future after-tax labour income
Human wealth
Future real interest rates
Figure 17.1 Expectations and spending: the channels
Consumption
Non-human wealth
Future real dividends
Future real interest rates
Future nominal interest rates
Future aftertax profits
Investment
Future real interest rates
Present value of after-tax profits
Expectations affect consumption and investment decisions, both directly and through asset prices.
A decrease in current and expected luture nominal interest rates leads to an increase in bond prices, which leads to an increase in non-human wealth and, in turn, to an increase in consumption. Note that in the case ol bones it is nominal rather than real interest rates that matter, because bonds arc claims to dollars rather than goods in the future.)
The way of dividing time between today' and 'later' is the way many of us organise our own life.Think of'things to do today' versus 'things 4 that can wait'.
See equation (14.8) in Chapter 14. which itself < extended the relation derived in Chapter 5 (equation [5.2]) to allow for a distinction between the real interest rate and the nominal interest rate.
An increase in current and expected future real altcr-tax profits, or a decrease in current and expected future real interest rates increases the present value ot real after-tax profits, which leads, in turn, to an increase in investment.
Expectations and the IS relation
A model that gave a detailed treatment of consumption and investment along the lines suggested in Figure 17.1 would be very complicated. It can be done—and it is done in the large empirical models that macrocconomists build to understand the economy and analyse policy—but this isn't the place for such complexity. We want to capture the essence ol what you have learned so tar. how consumption and investment depend on expectations ol the luture, without getting lost in the details.
To do so. we make a major simplification. We reduce the present and the future to only two periods: l a current period, which you can think ol as the current year- and 1 a future period, which you can think of as all future years lumped together. This way, we don't have to keep track ot expectations about each luture year.
Having made this assumption, the question becomes: How should wc write the IS relation lor the current period? Earlier, we derived the following equation for the IS relation:
V = C(Y - T) + K%r) + С
Wc assumed that consumption depended only on current income, and investment depended only on current output and the current real interest rate. We now want to modify this lo lake into account the effect of expectations both on consumption and on investment. We proceed in two steps:
First we simply rewrite the equation in more compact form, but without changing its content. For that purpose let's define aggregate private spending as the sum of consumption and investment spending:
A{Y,T,r) = C(Y - T) + KY,r)
The reason for doing so ► is to group together the two components of demand. С and /. which both depend on expectations. We continue to treat G, government spending, as exogenous— unexplained within our model. Note that we used A in earlier chapters for something quite different—technology. Don't be confused!
(17.1)
where A stands lor aggregate private spending, or. simply, private spending. With this notation we can rewrite the IS relation as
Y = A(Y,T,r) + G
The properties of aggregate private spending, A, follow Irom the properties ol consumption and investment derived in earlier chapters.
- Aggregate private spending is an increasing Iunction of income, Y: higher income (equivalently. output) increases consumption and investment.
Aggregate private spending is a decreasing function ol taxes. T: higher laxes decrease consumption.
Aggregate private spending is a decreasing function of the real interest rate, r-. a higher real interest rate decreases investment. The first step only simplified notation. Now comes the task ol extending equation П7.1 to reflect the role of expectations. The natural extension is to allow spending to depend not only on current variables but also on their expected values in the future period:
Y » A(YJ,r,Y",T\r"-) + G (+,-- + , - )
Primes denote future values, and the superscript с denotes an expectation so Y'r, T1' and rv denote future expected income, luture expected taxes and the future expected real interest rate, respectively. The notation is a bit heavy, but what il captures is straightforward:
- increases in either current or expected future income increase private spending
- increases in either current or expected future taxes decrease private spending
- increases in either the current or expected future real interest rate decrease private spending.
With goods market equilibrium now given by equation (17.21, Figure 17.2 shows the new IS curve. As usual, to draw the curve, we take all variables other than current output, V. and the current real interest rate, r, as given. Thus, the IS curve is drawn for given values of current and future expected taxes, T and T'e, for given values ol expected future output, Y'*, and for given values of the expected luture real interest rate, rv
The new IS curve, based on equation (17.2), is still downward sloping, for thc same reason as in Chapter 5: a decrease in the current real interest rate leads to an increase in spending. This increase in spending leads, through a multiplier elfect. to an increase in output. We can say more however. The new IS curve is much steeper than the IS curve we drew in earlier chapters. Put another way, everything being the same, a large decrease in the current interest rate is likely to have only a small effect on equilibrium output.
Fo see why thc effect is small, take point A on the IS curve in Figure 17.2, and consider the effects ot a decrease in the real interest rate. The effect of the decrease in the real interest rate on output depends on the strength of two effects: the effect of the real interest rate on spending given income and the size ol the multiplier. Let's examine each one in turn.
17.2)
Notation: Primes ( ) stand for values of the variables in the future period.
The superscript e stands for 'expected'. ►
Г or Г't - A t ► Tor Г'Т-Ai
r or r" t -> Л !
• A decrease in the current real interest rate, given unchanged expectations of the future real interest rale, doesn't have much effect on spending. We saw why in the previous chapters: a change in only thc current real interest rale doesn't lead to large changes in present values, and so doesn't lead to
Figure 17.2
V» £ ♦
S r8
С
3
U
The new IS curve
ЛТ > 0, or < AT'' > 0, or Лг'° > О,
iG > 0, or
AY'' > 0
Suppose you want a thirty-year loan. 3rd the one-year interest rate goes down from 5 per cent to 2 per cent. All future expected one- year rates remain the same By how much does the thirty-year interest rate come down? (If you need to. look at the relation between short-term Interest rates and long- term interest rates in Chapter 15.)
4 Suppose your firm decides to give all employees a one-time bonus of $10.000. This
isn't expected to happen again. By how much will you increase your consumption this year? (If you need to, look at the discussion of consumption behaviour in Chapter 16.)
У А Ув
Current output, Y
The LM relation revisited
The LM relation we derived in Chapter 4 and have used until now was given by
M
у УВД (17.3)
where .VI P is the supply ol money and YL(t') is the demand tor money. Equilibrium in linanciai markets requires that the supply of money he equal to the demand lor money. The demand lor money depends on real income and on thc short-term nominal interest rale—the opportunity cost of holding money. We derived ihis demand for money before thinking about expectations. Now that we have, the question is whether we should modify equation (17.3). The answer—we arc sure this will be good news—is 'no'.
Think of your own demand for money. I low much money you want to hold today depends on your currcnt level ol transactions, not on the level ol transactions you expect next year or the year alter,- there will be time to adjust your money balances to your transaction level if it changes in the future. Ard the opportunity cost of holding money today depends on the currcnt nominal interest rate, not on the expected nominal interest rate next year or thc year after. It short-term interest rates were to increase in the future, increasing the opportunity cost of holding money then, the time to reduce your money balances would be then, not now.
So, in contrast to the consumption decision, the decision as to how much money to hold is myopic, depending primarily on current income and the current short-term nominal interest rate. We can st II think ol the demand lor money as depending on the current level ol output and the current nominal interest rate, and use equation 17.3' to describe thc determination ot thc nominal interest rate in the current period.
To summarise: We have seen that expectations about the luture play a major role in spending decisions. This implies that expectations enter the IS relation. Private spending depends not only on current output and the current real interest rat. but also on expected future output and the expected future real interest rate.
We explored the role of changing expectations of inflation on the relation between the nominal interest rate and the real interest rate in Chapter 14. Leaving changes in expected inflation aside will keep the analysis simpler here.You have, however, all the elemencs you need to think through what would happen if we also allowed' expectations of current inflation and future inflation to adjust How would these expectations adjust? Would this lead to a larger or a smaller effect on output in the current period?
In contrast, the decision about how much money to hold is largely myopic. The two variables entering the LM relation are slill current income and ihe current nominal interest rate.
I 7.2 MONETARY POLICY, EXPECTATIONS AND OUTPUT
When the RBA loosens monetary policy—therefore decreasing the current nominal interest rate, i— the effect on the current and the expected luiure real interest rates depends on two factors:
• Whether the easier monetary policy now leads financial markets to revise their expectations ol the hitnre nominal interest rate, f'.
• Whether the easier monetary policy now leads financial markets to revise their expectations of both current inflation and luiure inflation тг and ir'e. If, for example, the change leads financial markets to expect more inllation in the luture—so тг1'" increases—the expected future real interest rate, r'1', will decrease for a given cxpectcd future nominal interest rate, i"1'.
To make things simpler, we will leave aside here the second factor—the role of changing expecta¬tions of inflation—and focus on the lirst, the role of changing expectations ol the future nominal interest rate. Thus, we will assume lhal expected current inflation and expected future inflation are both equal to zero. In this case, we need not distinguish between ihe nominal interest rate and the real interest rate, as they are equal, and we can use the same letter lo denote both. Let r denote the current real (and nominal i interest rate, and r'' denote the expected future real (and nominal' interest rate.
4 The IS relation is the same as equation (17.2). The LM relation is now in terms of the real interest rate—which here is equal to the nominal interest rate.
(17.4)
(17.5)
With this simplification wc can rewrite the IS and LM relations in equations 17.2) and > 17.3) as
IS-. Y = A(YJ,r,Y'e,T"\r'e) + G ^ j
There is no need to distinguish here between the real interest rate and the nominal interest rate: given zero expected inflation, they are the same.
LM: -j = YL(r)
The corresponding /S and LAI curves arc drawn in l igure 17.3. We are still assuming that the RBA is choosing the interest rate now the real interest rate . and the money supply is endogenously adjusting to shilt the LM curve to go through the equilibrium point. The vertical axis measures ihe current interest rate, г.- the horizontal axis measures current output, Y. The IS curve is steeply downward sloping. We saw earlier the reason why: for given expectations, a change in the current interest rate has a limited effect on spending, and the multiplier is small. The /..VI is upward sloping. An increase in income leads to an increase in the demand lor money. Given the supply of money, the result is an increase in the interest rale. Equilibrium in goods and financial markets implies that the economy is at point A, with the RBA choosing r, and equilibrium output. Уд, read off from the IS curve.
Current output, y
Now suppose that the economy is in a recession at point A, and the RBA decides to lower the current real) interest rate.
Assume lirst that this expansionary monetary policy doesn't change expectations ol either the future interest rate or the future output. In Figure 17.4, the interest rate is cut to Гц, and so the LM shifts down, from LM to LM". (Because wc already use primes to denote future values ol thc variables, we will use double primes [such as in L.VT] to denote shilts in curves in this chapter. T he equilibrium moves from point A to point B, with higher output. The steep IS curve, however, implies that the easier monetary policy has only a small effect on output. Changes in the current interest rate, unaccompanied by changes in expectations, have only a small eflect on spending, and in turn a small effect on output.
Is it reasonable, however, to assume lhat expectations are unaflecied by an expansionary monetary policy? Isn't it likely that, as the RBA decreases the current interest rate, financial markets anticipate lower interest rates in the future as well, along with higher future output stimulated by this lower future interest rate? What happens it they do? At a given current interest rate, prospects of a lower future interest rale and ol higher future output both increase spending and output; they shilt the IS curve to thc right, from IS to IS". The new equilibrium is given by point C, at the current interest rale rg chosen by the RBA. Thus, while the direct effect ot the expansion in the monetary policy on output is limited, the lull effect, once changes in expectations are taken into account is much larger.
To summarise: You have just learned an important lesson. The effects of monetary policy—of any type of macroeconomic policy, for that matter—depend crucially on the policy's effect on expectations.
II a monetary expansion leads financial investors, firms and consumers to revise their expectations ot future interest rates and output, then the effects of the monetary expansion on output may be very large.
Bui il expectations remain unchanged, the effects of ihe monetary expansion on output will be small; or. to put ii another way. to achieve iis monetary policy objective, the central bank would need a larger change in the current interest rate.
Given expectations, a ► reduction in the current interest rate leads to a movement down the steep IS curve, and thus to a small increase in У.
If the expansionary ► monetary policy leads to an increase in У and a decrease in r'', the IS curve shifts to the right, leading to a larger increase in Y.
We can link this discussion to our discussion in Chapter 15, ot the effects ot changes in monetary policy in thc slock market. Many ol the same issues were present there. If, when the change in monetary policy takes place, it comes as no surprise to investors, firms and consumers, then expectations won't change. The stock market will react only a little, il at all. And output will change only a little, it at all. But, il thc change comes as a surprise and is expected to last, expectations of future output go up. expectations ol future interest rates come down, ihe stock market booms and output increases.
Figure 17.4
Га YB Yc
Current output, y
The effects of an expansionary monetary policy
At this stage, you may have become very sceptical about whether macroeconomists can say much about the effects ol policy, or the ellects of other shocks. Il the effects depend so much on what happens to expectations, can macroeconomists have any hope of predicting what will happen? The answer is yes'.
Saying that the effect ol a particular policy depends on its effect on expectations isn't the same as saying that anything can happen. Expectations aren't arbitrary. Ihe manager of a fund who has to decide whether to invest in slocks or bonds, or ihe lirm thinking about whether to build a new plant, or a consumer thinking about how much he should save lor retirement—all give a lot of thought to what may happen in the future. We can think ol each of them as forming expectations about the future by assessing the likely course of future expected policy and then working out the implications lor future activity. II they don't do it themselves—most of us don't spend our time solving macroeconomic models before making decisions—thev do so indirectly, by watching TV and reading newsletters and news¬papers, which themselves rely on the predictions of public and private forecasters. Economists refer to expectations lormed in this forward-looking manner as rational expectations. The introduction of the assumption ol rational expectations is one ol the most important developments in macroeconomics in the last thirty years. It has largely shaped the way macroeconomists think about policy. It is discussed further in the focus box Rational expectations'.
FOCUS 'BOX
We could go back and think about the implications ol rational expectations in the case ol a monetary expansion we have iust studied. It will be more fun to do this in the context ot a change in liscal policy, and this is what we now turn to.
RATIONAL EXPECTATIONS
Most macroeconomists today routinely solve their models under the assumption of rational expectations.This wasn't always the case. The last thirty years in macroeconomic research are often callcd the 'rational expectations' revolution.
The importance of expectations is an old theme in macroeconomics. But until the early 1970s, macro- economists thought of expectations in one of two ways.
• One was as animal spirits (from an expression Keynes introduced in the General Theory to refer to movements in investment that couldn't be explained by movements in current variables). Shifts in expectations were considered important but were unexplained.
• The other was as the result of simple, backward-looking rules. For example, people were often assumed to have static expectations, to expect the future to be like the present. (We used this assumption in discussing the Phillips curve in Chapter 8 and in exploring investment decisions in Chapter 16.) Or people were assumed to have adaptive expectations. If, for example, their forecast of a given variable in a given period turned out to oe too low, people were assumed to 'adapt' by raising their expectation for the value of the variable for the following period. For example, seeing an inflation rate higher than they had expected led people to predict more inflation in the future than they had previously anticipated.
In the early 1970s. a group of macroeconomists led by Robert Lucas (at Chicago) and Thomas Sargent (then at Chicago, now at Stanford) argued that these assumptions didn't reflect the way people form expectations. (Robert Lucas received the Nobel Prize in 1995 for his work on expectations.) They argued that, in thinking about the effects of alternative policies, economists should assume that people have rational expectations, that people look to the future and do the best job they can in predicting it.This isn't the same as assuming that people know the future, but rather that they use the information they have in the best possible way.
Using the popular macroeconomic models of the time, Lucas and Sargent showed how replacing traditional assumptions about expectations formation by the assumption of rational expectations could fundamentally alter the results. We saw. for example, in Chapter 9 how Lucas challenged the notion that disinflation necessarily required an increase in unemployment for some time. Under rational expectations,
he argued.a credible disinflation policy might be able to decrease inflation without any increase in unemploy¬ment. More generally. Lucas and Sargent's research showed the need for a complete rethinking of macroeconomic models under the assumption of rational expectations, and this is what has happened since.
Most macroeconomists today use rational expectations as a working assumption in their models and in their analyses of policy. This isn't because they believe that people always have rational expectations. There are undoubtedly times when people, firms or financial market participants lose sight of reality and become too optimistic or too pessimistic. But these are more the exception than the rule, and it isn't clear that economists can say much about those times anyway. In thinking about the likely effects of a particular economic policy, the best assumption to make seems to be that financial markets, people and firms will do the best they can to work out its implications. Designing a policy on the assumption that people will make systematic mistakes in responding to it is unwise.
run and medium-run effects of charges in fiscal policy in Section 7.5, and the long-run effects in Section 11.2.
So. why did it take until the 1970s for rational expectations to become a standard assumption in macroeconomics? Largely because of technical problems. Under rational expectations, what happens today depends on expectations of what will happen in the future. But what happens in the future depends on what happens today. The success of Lucas and Sargent in convincing most macroeconomists to use rational expectations comes not only from the strength of their case but also from showing how it could actually be done. Much progress has been made since in developing solution methods for larger and larger models.Today, a number of large macroeconometric models are solved under the assumption of rational expectations. (A simulation from such a model was presented in Chapter 7.You will see another example in Chapter 25.)
17.3 DEFICIT REDUCTION, EXPECTATIONS AND OUTPUT
Rccall the conclusions reached in The Core about the effects of a budget deficit reduction:
• In the medium run and in the long run, a budget delicil reduction has beneficial effects lor the economy. In the medium run, a lower budget delicil implies higher saving and higher investment. In the long run higher investment translates into higher capital and thus higher output.
• In the short run however, a reduction in the budget deficit, unless it is offset by a monetary We discussed the short- ► expansion, leads to a reduction in spending, and so to a contraction in output.
Il is this adverse short-run effect that—in addition to the unpopularity of increases in taxes or reductions in socially important government programs—olien deters governments from tackling their budget dclicit. Why take the risk of a recession now, lor net benefits thai will accrue not now but later. in the future?
In lhe recent past, however, several economists have argued that a deficit reduction may actually increase output even in the slwrt run. 1 heir argument: ll people take into account the luture beneficial effects of deficit reduction, their expectations about the future may improve enough lo lead to an increase—rather than a decrease—in current spending, and so to an increase in current output. This section presents their argument more formally. Thc focus box Can a budget dclicit reduction lead lo an output expansion? Ireland in the 1980s' reviews some ol the supporting evidence.
Assume that the economy is described by equation i I7.41 for the IS relation and equation < 17.5) for the LM relation. Again, we are ignoring inllation effects, assuming for simplicity thai nominal and real interest rates arc the same. Later in this section we will think about how inflation changes allcct our conclusions via monetary policy. Now suppose that the government announces a program to reduce the deficit, through decreases in both current spending, G, and luture spending, G''. What will happen to output in this period?
The role of expectations about the future
Suppose first that expectations ol future output ! V' > and ol the luture interest rate I r'' don't change. Then, we get ihe standard answer: the decrease in government spending in the current period leads to a shilt in the IS curve to the left, and so to a decrease in equilibrium output.
The crucial question, therefore, is what happens to expectations. To answer, let us go back to what you learned in the core about the ellccts ot a deficit reduction in the medium run and the long run:
• In the medium run, a deficit reduction has no effect on output. It leads, however, to a lower real interest rate and to higher investment. These were two ol the main lessons ol Chapter 7. Let's review the logic behind each.
Recall that, when we look at the medium run, wc ignore the effects ol capital accumulation on output. So, in the medium run, the natural level of output depends on the level ol productivity (taken as given) and on the natural level of employment. The natural level of employment depends in turn on the natural rate ol unemployment. II spending by the government on goods and services doesn't affcct the natural rate of unemployment—and there is no obvious reason why it should— then changes in spending won't affcct the natural level of output. Therefore, deficit reduction has no effect on the level ot output in the medium run.
Now recall that output must be equal to spending, and that spending is the sum of public spending and private spending. Given that output is unchanged and that public spending is lower, private spending must be higher. Higher private spending requires a lower equilibrium real interest rate. The lower real interest rate leads to higher investment, and thus to higher private spending, which offsets the decrease in public spending and leaves output unchanged.
• In the long run—that is, taking into account the effects of capital accumulation on output—higher investment leads to a higher capital stock, and thus to a higher level ol output.
This was the main lesson of Chapter I I. The higher the proportion ol output saved or invested (investment and saving must be equal for the goods market lo be in equilibrium), the higher the capital stock, and thus the higher the level of output in the long run.
We can think of our future period as including both the medium and the long run. If people, firms and linancial market participants have rational expectations, then, in response to the announcement of a delicit reduction, they will expect these developments to take place in the future. Thus, they will revise their expectation of future output (V') up, and their expectation of the future interest rate \ r''') down.
Back to the current period
We can now return to the question of what happens this period in response to the announcement and start of the deficit reduction program. Figure 17.5 draws the IS and LM curves for the current period. In response to the announcement of the deficit reduction, there arc now three factors shilling the IS curve:
• Current government spending (G) goes down, leading to a shilt of the IS curve to the left. At a given interest rate, the decrease in government spending leads to a decrease in total spending and, so, to a decrease in output. This is the standard cffect of a reduction in government spending, and the only one taken into account in the basic IS-LM model.
• Expected future output (Y''"l goes up—the long-run effect of capital accumulation—leading to a shift of the IS curve to the right. At a given interest rale, the increase in expected future output leads to an increase in private spending, increasing output.
• The expected future rca! interest rate goes down—the medium-run real interest rate effect—leading to a shift of the IS curve to the right. At a given current interest rate, a decrease in the future interest rate stimulates spending and increases output.
In the medium run: output doesn't change and investment i increases.
4 In the long run: investment increases, capital increases and output increases.
What is the net effect ot these three shilts in the IS curve? Can the effect of expectations on consumption and investment spending offset the decrease in government spending? Without much more information about the exact form of the IS curvc, about the details ot the deficit reduction program and about the short-term interest rate response ol the central bank, we cannot tell which shifts will dominate and whether output will go up or down. But our analysis tells us that both cases arc possible, that output may go up in response lo the deficit reduction. And it gives us a few hints about when this might happen. Note that the smaller the decrease in current government spending (G), the
_L
Current output, y
О
Figure 17.5 The effects of a fiscal deficit reduction on current output
• Or take an economy where the government has, in cflect, lost control ol its budget: government spending is high tax revenues are low, and the deficit is very large. In such an environment, a credible deficit reduction program is also more likely to increase output in the short run. Before the announcement ol the program, people may have expected major political and economic trouble in the future. The announcement of a program ol deficit reduction may well reassure people that the government has regained control, and that the future is less bleak than they anticipated. This decrease in pessimism about the future may lead to an increase in spending and output, even if taxes are increased as part of the deficit reduction program.
To summarise: A program of deficit reduction may increase output even in the short run. Whether it docs or not depends on many lactors, in particular:
• The credibility of the program. Will spending be cut or taxes increased in the luiure as announced?
• The timing of the program. How large arc spending cuts in the future relative to current spending cuts?
• The composition of the program. Does the program remove some of the distortions in ihe economy?
• The state of government finances in the first place. How large is the initial deficit? Is this a 'last chance' program? What will happen it it fails?
This gives you a sense ot the importance of expectations in determining the outcome, and a sense ol ihe complexities involved in the use ol liscal policy in such a context. The model that wc have developed in this chapter is the basis of modern dynamic macroeconomic analysis. We will use it again in Chapter 22 when we discuss the macroeconomic implications of an acute financial crisis like the one experienced in 2008.
CAN A BUDGET DEFICIT REDUCTION LEAD TO AN OUTPUT EXPANSION? IRELAND IN
Ireland went through two major deficit reduction programs in the 1980s:
1. The first program was started in 1982. In 1981 the budget deficit had reached a very high 13 per cent of GDP. Government debt, the result of the accumulation of current and past deficits, was 77 per cent of GDP. also a very high level. The government clearly had to regain control of its finances. Over the next three years it embarked on a program of deficit reduction, based mostly on tax increases. This was an ambitious program. Had output continued to grow at its normal rate, the program would have reduced the deficit by 5 per cent of GDP.
The results were dismal. As shown in line 2 of Table I, output growth was low in 1982 and negative in 1983. Low growth was associated with a major increase in unemployment, from 9.5 per cent in 1981 to 15 per cent in 1984 (line 3). Because of low output growth, tax revenues—which depend on the level of activity—were lower than anticipated.The actual deficit reduction, shown in line I. was only 3.5 per cent of GDP. And the result of continuing high deficits and low GDP growth was a further increase in the ratio of debt to GDP, to 97 per cent in 1984.
2. A second attempt was made, starting in February 1987. At the time, things were still very bad. The 1986 deficit was 10.7 per cent of GDP. and debt stood at 116 per cent of GDP. a record high in Europe at the time.This new program of deficit reduction was different from the first.The focus was more on a reduction of the role of government and a decrease in government spending, rather than on an increase in taxes.The tax increases in the program were achieved through a tax reform widening the tax base, and without an increase in the marginal tax rate (the highest tax rate on income).The program was again very ambitious. Had output grown at its normal rate, the reduction in the deficit would have been 6.4 per cent of GDP.
As you will see in Chapter 24, a very large 4 deficit often leads to very high money creadon and. soon after, to very high inflation. Very high inflation leads not only to economic trouble but also to political instability.
Note how far we are from the results of Chapter 3 where, by choosing spending and taxes wisely, the government could achieve any level of output it wanted. Here. * even the direction of the effect of a deficit reduction on output is ambiguous.
The results of the second program could not have been more different from the results of the first. The years 1987 to 1989 showed strong growth, with average GDP growth exceeding 5 per cent. The unemployment rate was reduced by 2 per cent. Because of strong output growth, tax revenues were stronger than anticipated, and the deficit was reduced by nearly 9 per cent of GDP.
Several economists have argued that the striking difference between the results of the two programs can be traced to the different reaction of expectations in each case.The first package, they argue, focused on tax increases and didn't change what many people saw as too large a role of government in the economy. The second, with its focus on cuts in spending and on tax reform, had a much more positive impact on expectations, and so a positive impact on spending and output.
Are these economists right? One variable, the household saving rate—defined as disposable income minus consumption, divided by disposable income—strongly suggests that expectations are an important part of the story.To interpret the behaviour of the saving rate, recall the lessons from Chapter 16 about consumption behaviour. When disposable income grows unusually slowly or goes down—as it does in a recession— consumption typically slows down or declines by less than disposable income, as people expect things to improve in the future. Put another way. when the growth of disposable income is unusually low or negative, the saving rate typically comes down. Now look (in line 4) at what happened from 1981 to 1984: despite low growth throughout and a recession in 1983, the household saving rate actually increased a little during that period. Put another way. people reduced their consumption by more than the reduction in disposable income. The reason must be that they were very pessimistic about the future.
Table 1 Fiscal and other macroeconomic indicators, Ireland, 1981-84 and 1986-89
1981 1982 1983 1984 1986 1987 1988 1989
1. Budget deficit (% of GDP) -13.0 -13.4 -11.4 -9.5 -10.7 -8.6 -4. 5 -1.8
2. Output growth rate (%) 3.3 2.3 -0.2 4.4 -0.4 4.7 5.2 5.8
3. Unemployment rate (%) 9.5 1 1.0 13.5 15.0 17.1 16.9 16.3 15.1
4. Household saving rate (% of disposable income) 17.9 19.6 18.1 18.4 15.7 12.9 1 1.0 12.6
1 1
SOURCE- CtCD Economic Out/ook.June 1998.
Now turn to 1986 to 1989. During that period, economic growth was unusually strong. By the same argument as in the previous paragraph, we would have expected consumption to increase less strongly, and thus the saving rate to increase. Instead, thc saving rate decreased very strongly, from 15.7 per cent in 1986 to 12.6 per cent in 1989. Consumers must have become much more optimistic about the future to increase their consumption by more than the increase in disposable income.
The next question is whether this difference in the adjustment of expectations over the two episodes can be attributed fully to the differences in the two fiscal programs. The answer is 'no'. Ireland was changing in many ways at the time of the second fiscal program. Productivity was increasing much faster than real wages, reducing the cost of labour for firms. Attracted by tax breaks, low labour costs and an educated labour force, many foreign firms were coming to Ireland to create new plants. These factors played a major role in the expansion of the late 1980s. Irish growth has been very strong ever since (that is, until late 2008, when it suffered badly in the global financial crisis), with average output growth exceeding 6 per cent since l990.This long expansion is surely due to other factors than fiscal policy. Nevertheless, the change in fiscal policy in 1987 probably played a role in convincing people, firms (including foreign firms) and financial markets that the government was regaining control of its finances. And the fact remains that the substantial deficit reduction of 1987-89 was accompanied by a strong output expansion, not by the recession predicted by the basic IS-LM model.
For a more detailed discussion, look ol Francesco Giavozzi and Marco Pagano. 'Can severe fiscal contractions be expansionary? Tales of two small European countries'. NBER Macroeconomics Annual. 1990, pp. 75-110.
A survey of what we have learned by looking at progmms of deficit reduction around the world is given in 'An empirical analysis of fiscal adjustments', by John МсЭетюи and Robert Wescoii, IMF working paper. June 1996.
Spending in the goods market depends on current and expected future output and on the current and the cxpectcd future real interest rate.
Expectations affect demand and, in turn output: changes in expected future output or in the expected future real interest rate lead to changes in spending and in output today.
By implication, the effects ol any policy on spending and output depend on whether and how policy affects expectations ot future output and expectations ol the luture real interest rate. Rational expectations' is the assumption that people, lirms and participants in financial markets form expectations ol the future by assessing the course of future expected policv and then working out the implications lor luture output, future interest rates, and so on. While it is clear that most people don't go through this exercise themselves, we can think ol them as doing so indirectly by reiving on the predictions ol public and private forecasters.
Although there are surely cases where people, firms or financial investors don't have rational expectations, the assumption ol rational expectations seems to he the best benchmark to evaluate the potential effects ol alternative policies. Designing a policy on the assumption that people will make systematic mistakes in responding to it would be unwise.
Changes in monetary policy affcct the current short-term nominal interest rate. Spending, however, depends instead on the current and the expected future real interest rate. Thus, the effect of monetary policy on activity depends crucially on whether and how changes in the short-term nominal interest rate lead to changes in the currcnt and the expected luture real interest rale.
A budget deficit reduction may lead to an increase rather than a decrease in output. This is because expectations of higher output and lower interest rates in the future may lead to an increase in spending that more than offsets the reduction in spending coming from the direct ellect of the delicit reduction on total spending.
KEY TERMS
• aggregate private spending, private • adaptive expectations, 395 spending, 390 . backloading, 398
• rational expectations, 395 . crcciibility, 398
• animal spirits, 395
QUESTIONS AND PROBLEMS
Quick check
I. Using the information in this chapter, label each of the following statements 'true', 'false' or
'uncertain'. Explain briefly.
a. Changes in the current one-year real interest rate are likely to have a much larger effect on spending than changes in expected future one-year real interest rates.
b. The introduction of expectations in the goods market model makes the IS curve (latter, although it is still downward sloping.
c. Currcnt money demand depends on current and expected luture nominal interest rates.
d. The rational expectations assumption implies that consumers must take into account the effects ot luture liscal policy on output.
с Expected future fiscal policy affects expected luture economic activity but not current economic activity.
f. Depending on its elfect on expectations, a tiscal contraction may actually lead to an economic expansion.
g. Ireland's experience with delicit reduction programs in 1982 and 1987 provides strong evidence against the hypothesis that deficit reduction can lead to an output expansion.
2. During the late 1990s, main/ observers claimed thai the economies of many rich countries had transformed into a Xew Economy, and that this justified the very high values for stock prices observed at the time.
a. Discuss how the belie! in the New F.conomy, combined with the increase in stock prices allected consumption spending.
b. Stock prices subsequently decreased. Discuss how this might have affected consumption.
3. For each of the following, determine whether the IS curve, the I .M curve, both curves or neither curve shifts. In each case, assume that expected current in flation and future inflation are equal to zero, and that no other exogenous variable is changing.
a. A decrease in the expected luture real interest rate.
b. A decrease in the current short-term nominal interest rate.
c. An increase in expected future taxes.
d. A decrease in expected luture income.
4. Consider the following statement. 'The rational expectations assumption is unrealistic because, essentially, it amounts to the assumption lhat every consumer has perfect knowledge of the economy.' Discuss.
5. A new prime minister, who promised during the campaign that she would cut taxes, has just been elected. People trust that she will keep her promise, but that the tax cuts will be implemented only in the future. Determine the impact of the election on current output, the current interest rate and current private spending, under each of the following assumptions, tin each case, indicate what you think will happen to Y'v. r'*' andTv. and then how these changes in expectations affect output today.)
a. The RBA decides not to change the interest rate.
b. The RBA decides to prevent any change in future output.
c. The RBA decides to prevent any increase in thc future interest rate.
d. The RBA acts very strongly to keep inllation at its target rate.
Dig Deeper
6. In 1992 the US deficit was US$290 billion. During the US presidential campaign, the large deficit emerged as a major issue. So. when President Clinton won the election, deficit reduction was the first item on the new administration's agenda.
a. What does deficit reduction imply lor the medium run and the long run? What are the
advantages ol reducing the delicil? In the final version passed by Congress in August 1993, thc deficit reduction package included a reduction of USS20 billion in its first year, increasing gradually to US$131 billion four years later. b Why was the deficit reduction package backloaded? Are there any advantages or disadvantages :o this approach?
In February 1993 President Clinton presented the budget in his State of the Union address. He asked Alan Greenspan, the Fed chairman, to sit next to First Lady Hillary Clinton during the delivery of the address.
c. What was the purpose of this symbolic gesture? How can the fed's decision to use expansionary monetary policy in the future affect the short-run response ol the economy?
7. Suppose, in a hypothetical economy, that the governor of the RBA unexpectedly announces that he will retire in one year. At the same time, the treasurer announces his nominee to replace the retiring
RBA governor, linanciai market participants expect the nominee to be confirmed by parliament. They also believe that the nominee will conduct a more contractionary monetary policy in the future. In other words, market participants expect the interest rate to rise in the future.
a. Consider thc present to he the last year of the current RBA governor's term and thc luture to be the time after that. Given that monetary policy will be more contractionary in the future, what will happen to future interest rates and future output at least for a while, before output returns to potential GDP): Given that these changes in future output and future interest rates are predicted, what will happen to output and the interest rate in the present? What will happen to the yield curve on thc day of the announcement that the current RBA governor will retire in a year?
Now suppose that, instead of making an unexpected announcement, the RBA governor is required by law to retire in one year /there are limits on the term of the RBA governor), and financial market participants have been aware of this for some time. Suppose, as in part (aj, thai lhe treasurer nominates a replacement who is expected to conduct a more contractionary monetary policy than the current RBA governor.
b. Suppose that financial market participants are not surprised by the treasurer's choice. In other words, market participants had correctly predicted who the treasurer would choose as the nominee. Under these circumstances, is the announcement of the nominee likely to have any effect on the yield curve?
c. Suppose instead lhat thc identity of the nominee is a surprise and that linanciai market partici¬pants had expected the nominee to be someone who favoured an even more contractionary policy than the actual nominee. Under these circumstances, what is likely to happen to thc yield curve on the day ol the announcement? Hint: Be careful. Compared with what was expected, is the actual nominee expected to follow a more contractionary policy or a more expansionary policy?)
d. On I August 2006, Glenn Stevens was nominated to succeed Ian Macfarlane as RBA governor. Do an Internet search and try to learn what happened in financial markets on the day the nomination was announced. Were financial market participants surprised by the choice? II so, was Stevens believed to favour policies that would lead to higher or lower interest rates (as compared with the expected nominee) over the next three to five years?; You may also do a yield curve analysis for the period around Stevens' nomination. If you do this, use six-month yields on overnight indexed swaps and live-year Treasury bond interest rates.)
Explore further
8. Deficits and interest rates
The dramatic change in the LIS budget position after 2000 (from a surplus to a large and continuing deficit) reinvigorated the debate about the effect of fiscal policy on interest rates. This problem asks you to review theory ami evidence on this topic.
a. Review what theory predicts about liscal policy and interest rates. Suppose there is an increase in government spending and a decrease in taxes. Use an IS-LM diagram to show what will happen to the nominal interest rate in the short run and in the medium mn (assuming the Fed is following an interest rate rule and has an implicit inflation target). Assuming that there is no change in monetary policy, what does the IS-LM model predict will happen to the yield curve immediately alter an increase in government spending and a decrease in taxes?
During the first term of the G. W. Bush administration, the actual and projected federal budget deficits increased dramatically. Part of the increase in the deficit can be attributed to the recession of 2001. However, deficits and projected deficits continued to increase even after the recession had ended.
The following table provides budget projections produced by the Congressional Budget Office iCBOj over the period August 2002 to January 2004. These projections are for the total federal budget
deficit, so they include Social Security, which was running a surplus over the period. In addition, each projection assumes that current policy (as of the date of the forecast) continues into the future.
Date of forecast Projected five-year deficit as per cent of five-year GDP
August 2002 -0.4
January 2003 -0.2
August 2003 -2.3
January 2004 -2.3
1 1
b. Go lo ihe website ol ihe Federal Reserve Bank ol Si Louis,
The analysis you carried out in this problem is an extension of work by William C. Gale and Peter R. Orszag. See 'The economic effects of long-term fiscal discipline', Brookings Institution, 17 December 2002. Figure 5 in this paper relates interest rate spreads to CBO five-year projected budget deficits from 1982 to 2002.
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
The Open Economy
CHAPTER 18
Chapter 18 discusses the implications of openness in goods and financial markets. Openness in goods markets allows people to choose between domestic goods and foreign goods. An important determinant of their decisions is the real exchange rate—the relative price of domestic goods in terms of foreign goods. Openness in financial markets allows people to choose between domestic assets and foreign assets. This imposes a tight relation between the exchange rate, both current and expected, and domestic and foreign interest rates—a relation known as the interest parity condition.
CHAPTER 19
Chapter 19 focuses on equilibrium in the domestic goods market in an open economy. It shows how the demand for domestic goods now depends also on the real exchange rate. It shows how fiscal policy affects both output and the trade balance. It discusses the conditions under which a real depreciation improves the trade balance and increases output.
CHAPTER 20
Chapter 20 characterises goods and financial markets' equilibrium in an open economy. In other words, it gives an open economy version of the IS-LM model we saw in The Core. It shows how, under flexible exchange rates, monetary policy affects output not only through its effect on the interest rate, but also through its effect on the exchange rate. It shows how fixing the exchange rate also implies giving up the ability to change the interest rate.
CHAPTER 21
The next four chapters represent the second major extension of The Core. They look at the implications of openness—the fact that most economies trade both goods and assets with the rest of the world.
Chapter 21 looks at the properties of different exchange rate regimes. It shows how, in the medium run, the real exchange rate can adjust even under a fixed exchange rate regime. It then looks at exchange rate crises under fixed exchange rates, and at movements in exchange rates under flexible exchange rates. It ends by discussing the pros and cons of various exchange rate regimes, from the adoption of a common currency such as the euro, to the use of a currency board, to dollarisation.
CHAPTER ф
Openness in Goods and Financial Markets
18.1 OPENNESS IN GOODS MARKETS
Lets start by looking at how much Australia sells to and buys from the rest ol the world. Then, wc will be better able to think about the choice between domestic goods and /оreign goods, and the role of the relative price ol lorcign goods in terms ol domestic goods—the real exchange rale.
Exports and imports
Figure 18.1 plots ihe evolution of Australian exports and Australian imports, as ratios to GDP, since 1900. ('Australian exports means exports from Australia,- Australian imports means imports to Australia. i The Australian economy has always been a fairly open economy, with the exports to GDP ratio averaging 18 per cent over 100 years, and the import ratio averaging 17 percent. For a few years alter the end of World War II world commodity prices soared—wool prices were especially relevant to Australia then, and they actually doubled in 1950—51 This is the main explanation tor the spike in the middle ot Figure 18.1 In the 1950s, commodity prices moderated reducing the trade ratios. Note how these ratios have increased since I960, reaching 2 1 per ccnt lor exports) and 22 per cent (for imports) by 2008. Australia is now back to trading about the same amount (relative to its GDP) with the rest of the world as it did 100 years ago.
What is the current composition of Australia's exports and imports? In August 2008 65 percent of Australia's goods exports were mining products (ol which one-third was coal). 13 per cent were rural products, and the rest were manufactured products. For imports in August 2008. almost 75 percent were manufactured products anci 15 per ccnt were petroleum products. This is why the Australian economy is sensitive to the world price of commodities relative to the price of manufactured goods.
A closer look at Figure I 8.1 reveals two other interesting Icaturcs: • Both exports and imports declined sharply between 1929 and 1936. All over the world, countries thought they could lilt themselves out of the Great Depression by raising tariffs on foreign goods in the hope of increasing the demand lor domestic goods. In the United States, this was done
Комментариев нет:
Отправить комментарий