Household Behavior in the Macroeconomy: A Comprehensive Analysis

2. 17 Household and FirmBehavior in theMacroeconomy:A Further Look Chapter Outline Households: Consumption and Labor Supply DecisionsThe Keynesian Theory of Consumption: A Review The Life-Cycle Theory of ConsumptionThe Labor Supply DecisionInterest Rate Effects on ConsumptionGovernment Effects on Consumption and LaborSupply: Taxes and TransfersA Possible Employment Constraint on HouseholdsA Summary of Household BehaviorThe Household Sector Since1970Firms: Investment and Employment DecisionsExpectations and Animal SpiritsExcess Labor and Excess Capital EffectsInventory InvestmentA Summary of Firm BehaviorThe Firm Sector Since 1970Productivity and the Business CycleThe Relationship Between Output and UnemploymentThe Size of the Multiplier

3. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE KEYNESIAN THEORY OF CONSUMPTION: A REVIEW average propensity to consume (APC) The proportion of income households spend on consumption. Determined by dividing consumption (C) by income (Y). Although the idea that consumption depends on income is a useful starting point, it is far from a complete description of the consumption decision.

4. In the Keynesian theory of consumption: a. Consumption is a negative function of income. The lower your income, the more consuming you are likely to do. b. People who earn less spend less of their income on consumption than those who earn more. c. High-income households consume a smaller proportion of their income than low-income households. d. Consumption behaves like animal spirits. It is highly unpredictable.

5. In the Keynesian theory of consumption: a. Consumption is a negative function of income. The lower your income, the more consuming you are likely to do. b. People who earn less spend less of their income on consumption than those who earn more. c. High-income households consume a smaller proportion of their income than low-income households. d. Consumption behaves like animal spirits. It is highly unpredictable.

6. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE LIFE-CYCLE THEORY OF CONSUMPTION life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their expectations of lifetime income. permanent income The average level of one’s expected future income stream.

7. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE LIFE-CYCLE THEORY OF CONSUMPTION FIGURE 17.1 Life-Cycle Theory of Consumption

8. In the life-cycle theory of consumption, a. The more income you have, the more consuming you are likely to do. b. High-income households consume a smaller proportion of their income than low-income households. c. People tend to consume less than they earn during their main working years. d. All of the above.

9. In the life-cycle theory of consumption, a. The more income you have, the more consuming you are likely to do. b. High-income households consume a smaller proportion of their income than low-income households. c. People tend to consume less than they earn during their main working years. d. All of the above.

10. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE LABOR SUPPLY DECISION Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your consumption. The Wage Rate According to the substitution effect of a wage rate increase, a higher wage leads to a larger quantity of labor supplied—a larger workforce. According to the income effect of a wage rate increase, if we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less.

11. The data suggest that the substitution effect of a wage increase seems to win over the income effect. This means that: a. Higher wage rates usually lead to a larger labor supply. b. Higher wage rates usually lead to a lower labor supply. c. Higher wages may or may not increase labor supply. d. There is no relationship between wages and labor supply.

12. The data suggest that the substitution effect of a wage increase seems to win over the income effect. This means that: a. Higher wage rates usually lead to a larger labor supply. b. Higher wage rates usually lead to a lower labor supply. c. Higher wages may or may not increase labor supply. d. There is no relationship between wages and labor supply.

13. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE LABOR SUPPLY DECISION Prices nominal wage rate The wage rate in current dollars. real wage rate The amount that the nominal wage rate can buy in terms of goods and services. Households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions.

14. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE LABOR SUPPLY DECISION Wealth and Nonlabor Income nonlabor, or nonwage, income Any income received from sources other than working—inheritances, interest, dividends, transfer payments, and so on. Holding everything else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume, both now and in the future. An unexpected increase in nonlabor income will have a positive effect on a household’s consumption. An unexpected increase in wealth or nonlabor income leads to a decrease in labor supply.

15. All else the same, an unexpected increase in wealth or nonlabor income causes: a. An increase in labor supply, an increase in present consumption, and a decrease in future consumption. b. A decrease in labor supply, a decrease in present consumption, and an increase in future consumption. c. A decrease in labor supply, and an increase in both present and future consumption. d. No change in labor supply, but higher present and future consumption.

16. All else the same, an unexpected increase in wealth or nonlabor income causes: a. An increase in labor supply, an increase in present consumption, and a decrease in future consumption. b. A decrease in labor supply, a decrease in present consumption, and an increase in future consumption. c. A decrease in labor supply, and an increase in both present and future consumption. d. No change in labor supply, but higher present and future consumption.

17. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS INTEREST RATE EFFECTS ON CONSUMPTION A rise in the interest rate leads me to consume less today and save more. This effect is called the substitution effect of an interest rate change. There is also an income effect of an interest rate change on consumption. If a household has positive wealth and is earning interest on that wealth, a fall in the interest rate leads to a fall in interest income.

18. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS GOVERNMENT EFFECTS ON CONSUMPTION AND LABOR SUPPLY: TAXES AND TRANSFERS

19. If the substitution effect of a change in wages dominates, then an increase in income tax rates: a. Increases after-tax wages and increases labor supply. b. Increases after-tax wages and lowers labor supply. c. Lowers after-tax wages and increases labor supply. d. Lowers after-tax wages and lowers labor supply.

20. If the substitution effect of a change in wages dominates, then an increase in income tax rates: a. Increases after-tax wages and increases labor supply. b. Increases after-tax wages and lowers labor supply. c. Lowers after-tax wages and increases labor supply. d. Lowers after-tax wages and lowers labor supply.

21. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS A POSSIBLE EMPLOYMENT CONSTRAINT ON HOUSEHOLDS Households consume less if they are constrained from working. unconstrained supply of laborThe amount a household would like to work within a given period at the current wage rate if it could find the work. constrained supply of labor The amount a household actually works in a given period at the current wage rate.

22. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS A POSSIBLE EMPLOYMENT CONSTRAINT ON HOUSEHOLDS Keynesian Theory Revisited In Keynesian theory, current income determines current consumption. It is incorrect to think consumption depends only on income, at least when there is full employment. However, if there is unemployment, Keynes is closer to being correct because income is not determined by households. When there is unemployment, the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms.

23. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS A SUMMARY OF HOUSEHOLD BEHAVIOR • The following factors affect household consumption and labor supply decisions: • ■ Current and expected future real wage rates • ■ Initial value of wealth • ■ Current and expected future nonlabor income • ■ Interest rates • ■ Current and expected future tax rates and transfer payments

24. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE HOUSEHOLD SECTOR SINCE 1970 Consumption FIGURE 17.2 Consumption Expenditures, 1970 I–2005 II

25. Which category of expenditures is “smoother” over time? a. Expenditures on services and nondurable goods. b. Expenditures on durable goods. c. Housing expenditures. d. All of the above categories of expenditures are very smooth over time.

26. Which category of expenditures is “smoother” over time? a. Expenditures on services and nondurable goods. b. Expenditures on durable goods. c. Housing expenditures. d. All of the above categories of expenditures are very smooth over time.

27. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE HOUSEHOLD SECTOR SINCE 1970 Housing Investment FIGURE 17.3 Housing Investment of the Household Sector, 1970 I–2005 II

28. HOUSEHOLDS: CONSUMPTION AND LABORSUPPLY DECISIONS THE HOUSEHOLD SECTOR SINCE 1970 Labor Supply FIGURE 17.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2005 II

29. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS inputsThe goods and services that firms purchase and turn into output. Investment Decisions plant-and-equipment investmentPurchases by firms of additional machines, factories, or buildings within a given period. inventory investment Occurs when a firm produces more output than it sells within a given period.

30. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS Employment Decisions The demand for labor is quite important in macroeconomics. If the demand for labor increases at a time of less-than-full employment, the unemployment rate will fall. If the demand for labor increases when there is full employment, wage rates will rise.

31. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS Decision Making and Profit Maximization labor-intensive technology A production technique that uses a large amount of labor relative to capital. capital-intensive technology A production technique that uses a large amount of capital relative to labor.

32. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS EXPECTATIONS AND ANIMAL SPIRITS animal spirits of entrepreneurs A phrase coined by Keynes to describe investors’ feelings. Because expectations about the future are, as Keynes points out, subject to great uncertainty, they may change often. Thus animal spirits help to make investment a volatile component of GDP.

33. When Keynes referred to the animal spirits of entrepreneurs, he meant that: a. Investment decisions are always made with imperfect knowledge. b. Investment activity depends on psychology. c. Investment is based on expectations involving great uncertainty. d. All of the above.

34. When Keynes referred to the animal spirits of entrepreneurs, he meant that: a. Investment decisions are always made with imperfect knowledge. b. Investment activity depends on psychology. c. Investment is based on expectations involving great uncertainty. d. All of the above.

35. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS The Accelerator Effect At any given level of the interest rate, expectations are likely to be more optimistic and planned investment is likely to be higher when output is growing rapidly than when it is growing slowly or falling. accelerator effect The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output.

36. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS EXCESS LABOR AND EXCESS CAPITAL EFFECTS excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output. adjustment costs The costs that a firm incurs when it changes its production level—for example, the administration costs of laying off employees or the training costs of hiring new workers.

37. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS INVENTORY INVESTMENT The Role of Inventories stock of inventories (end of period) = stock of inventories (beginning of period)+ production – sales The Optimal Inventory Policy desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs).

38. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS INVENTORY INVESTMENT The Optimal Inventory Policy An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production. The level of a firm’s planned production path depends on the level of its expected future sales path. If a firm’s expectations of the level of its future sales path decrease, the firm is likely to decrease the level of its planned production path, including its actual production in the current period. Current production depends on expected future sales.

39. If the costs of adjusting production levels are greater than the costs of maintaining inventories, a. A firm will immediately adjust production to match any increases or decreases in sales. b. Output produced will tend to be less than output sold. c. A firm may lower production by less than a decrease in sales, allowing inventories to rise. d. Fluctuations in production will be greater than the corresponding fluctuations in sales.

40. If the costs of adjusting production levels are greater than the costs of maintaining inventories, a. A firm will immediately adjust production to match any increases or decreases in sales. b. Output produced will tend to be less than output sold. c. A firm may lower production by less than a decrease in sales, allowing inventories to rise. d. Fluctuations in production will be greater than the corresponding fluctuations in sales.

41. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS A SUMMARY OF FIRM BEHAVIOR • The following factors affect firms’ investment and employment decisions: • ■ Wage rate and cost of capital (the interest rate is an important component of the cost of capital) • ■ Firms’ expectations of future output • ■ Amount of excess labor and excess capital on hand • The most important points to remember about the relationship among production, sales, and inventory investment are: • ■ Inventory investment—that is, the change in the stock of inventories—equals • production minus sales • ■ An unexpected increase in the stock of inventories has a negative effect on future • production • ■ Current production depends on expected future sales

42. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS THE FIRM SECTOR SINCE 1970 Plant-and-Equipment Investment FIGURE 17.5 Plant and Equipment Investment of the Firm Sector, 1970 I–2005 II

43. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS THE FIRM SECTOR SINCE 1970 Employment FIGURE 17.6 Employment in the Firm Sector, 1970 I–2005 II

44. FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS THE FIRM SECTOR SINCE 1970 Inventory Investment FIGURE 17.7 Plant and Equipment Investment of the Firm Sector, 1970 I–2005 II

45. PRODUCTIVITY AND THE BUSINESS CYCLE productivity, or labor productivity Output per worker hour; the amount of output produced by an average worker in 1 hour. During expansions in the economy, output rises by a larger percentage than employment, and the ratio of output to workers rises. During downswings, output falls faster than employment and the ratio of output to workers falls. FIGURE 17.8 Employment and Output over the Business Cycle

46. PRODUCTIVITY AND THE BUSINESS CYCLE Productivity in the Long Run Productivity figures can be misleading when used to diagnose the health of the economy over the short run, because business cycles can distort the meaning of productivity measurements. Output per worker falls in recessions because firms hold excess labor during slumps. Output per worker rises in expansions because firms put the excess labor back to work. Neither of these conditions has anything to do with the economy’s long-run potential to produce output.

47. THE RELATIONSHIP BETWEEN OUTPUTAND UNEMPLOYMENT Okun’s Law The theory, put forth by Arthur Okun, that the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts.

48. THE RELATIONSHIP BETWEEN OUTPUTAND UNEMPLOYMENT Let E denote the number of people employed, let L denote the number of people in the labor force, and let u denote the unemployment rate. In these terms, the unemployment rate is u = 1 – E/L. The unemployment rate is 1 minus the employment rate, E/L. discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking for jobs, dropping out of the ranks of the unemployed and the labor force. The relationship between output and unemployment depends on the state of the economy at the time of the output change.

49. THE SIZE OF THE MULTIPLIER The value of the multiplier in reality is smaller than the simple multiplier. We can now summarize why. • There are automatic stabilizers. • The interest rate and the crowding-out effect. • The effect of expansionary policy on the price level. • The fact that firms hold excess capital and excess labor. • Inventories. • Expectations. The Size of the Multiplier in Practice In practice, the multiplier probably has a value of around 1.4. Its size also depends on how long ago the spending increase began.

50. REVIEW TERMS AND CONCEPTS inputs inventory investment labor-intensive technology life-cycle theory of consumption nominal wage rate nonlabor, or nonwage, income Okun’s Law permanent income plant-and-equipment investment productivity, or labor productivity real wage rate unconstrained supply of labor • accelerator effect • adjustment costs • animal spirits of • entrepreneurs • average propensity to consume (APC) • capital-intensive technology • constrained supply of labor • desired, or optimal, level of • inventories • discouraged-worker effect • excess capital • excess labor