Econ 9e One Click ch31

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look
PowerPoint Lectures for

Principles of Economics,
9e
; ;
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
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PART VI FURTHER MACROECONOMICS ISSUES
Household and Firm

Behavior in the
Macroeconomy: A
Further Look
31
Prepared by:
Fernando & Yvonn Quijano
PART VI FURTHER MACROECONOMICS ISSUES
Household and Firm

Behavior in the
Macroeconomy: A
Further Look
31
CHAPTER OUTLINE
Households: Consumption and Labor
Supply Decisions
The Life-Cycle Theory of Consumption
The Labor Supply Decision
Interest Rate Effects on Consumption
Government Effects on Consumption and
Labor Supply: Taxes and Transfers
A Possible Employment Constraint on
Households
A Summary of Household Behavior
The Household Sector Since 1970
Firms: Investment and Employment
Decisions
Expectations and Animal Spirits
Profit Maximization
Excess Labor and Excess Capital Effects
Inventory Investment
A Summary of Firm Behavior
The Firm Sector Since 1970
Productivity and the Business Cycle
The Short-Run Relationship Between
Output and Unemployment
The Size of the Multiplier
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Households: Consumption and Labor Supply Decisions

life-cycle theory of consumption A theory of

household consumption: Households make
lifetime consumption decisions based on their
expectations of lifetime income.
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FIGURE 31.1 Life-Cycle

Theory of Consumption
In their early working years,
people consume more than they
earn. This is also true in the
retirement years. In between,
people save (consume less than
they earn) to pay off debts from
borrowing and to accumulate
savings for retirement.
permanent income The average level of a

persons expected future income stream.
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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 supplieda 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.
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Prices
nominal wage rate The wage rate in current
dollars.
real wage rate The amount 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.
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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 households
consumption.
An unexpected increase in wealth or nonlabor
income leads to a decrease in labor supply.
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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.
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Government Effects on Consumption and Labor Supply:
Taxes and Transfers
TABLE 31.1 The Effects of Government on Household Consumption and Labor
Supply
Income Tax Rates
Transfer Payments
Increase
Decrease
Increase
Decrease
Effect on consumption
Negative
Positive
Positive
Negative
Effect on labor supply
Negative*
Positive*
Negative
Positive
*If the substitution effect dominates.

Note: The effects are larger if they are expected to be permanent instead of temporary.
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A Possible Employment Constraint on Households
Households consume less if they are constrained

from working.
unconstrained supply of labor The 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.
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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.
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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
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Consumption
FIGURE 31.2 Consumption Expenditures, 1970 I2007 IV

Over time, expenditures on services and nondurable goods are smoother than expenditures on durable
goods.
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Housing Investment
FIGURE 31.3 Housing Investment of the Household Sector, 1970 I2007 IV

Housing investment fell during the four recessionary periods since 1970. Like expenditures for durable
goods, expenditures for housing investment are postponable.
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Housing Investment
Housing Problems
Spread to the Rest of
the Economy
Decline in Home Prices
Accelerates: Feds Efforts
Have Only Muted Effect On
Mortgage Rates
Wall Street Journal
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Labor Supply
FIGURE 31.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others
16 and Over, 1970 I2007 IV
Since 1970, the labor force participation rate for prime-age men has been decreasing slightly.
The rate for prime-age women has been increasing dramatically.
The rate for all others 16 and over has been declining since 1979 and shows a tendency to fall during
recessions (the discouraged- worker effect).
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Firms: Investment and Employment Decisions

Expectations and Animal Spirits
animal spirits of entrepreneurs A term coined

by Keynes to describe investors feelings.
The Accelerator Effect

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.
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Profit Maximization
inputs The goods and services that firms

purchase and turn into output.
plant-and-equipment investment Purchases by
firms of additional machines, factories, or buildings
within a given period.
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.
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Excess Labor and Excess Capital Effects
excess labor, excess capital Labor and capital

that are not needed to produce the firms 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.
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inventory investment The change in the stock of
inventories.
The Role of Inventories
Stock of inventories (end of period) =
Stock of inventories (beginning of period)
+ Production - Sales
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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).
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The following factors affect firms investment and

employment decisions:
Firms expectations of future output
Wage rate and cost of capital (the interest rate

is an important component of the cost of
capital)
Amount of excess labor and excess capital on

hand
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The most important points to remember about the

relationship among production, sales, and
inventory investment are
Inventory investmentthat is, the change in

the stock of inventoriesequals 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.
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Plant-and-Equipment Investment
FIGURE 31.5 Plant-and-Equipment Investment of the Firm Sector, 1970 I2007 IV

Overall, plant-and-equipment investment declined in the four recessionary periods since 1970.
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Employment
FIGURE 31.6 Employment in the Firm Sector, 1970 I2007 IV

Growth in employment was generally negative in the four recessions the U.S. economy has experienced
since 1970.
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FIGURE 31.7 Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I2007 IV
The inventory/sales ratio is the ratio of the firm sectors stock of inventories to the level of sales. Inventory
investment is very volatile.
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productivity, or labor productivity Output per
worker hour; the amount of output produced by an
average worker in 1 hour.
FIGURE 31.8 Employment
and Output over the Business
Cycle
In general, employment does not
fluctuate as much as output over
the business cycle. As a result,
measured productivity (the outputto-labor ratio) tends to rise during
expansionary periods and decline
during contractionary periods.
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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 economys long-run
potential to produce output.
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The Short-Run Relationship Between Output and Unemployment
Okuns Law The theory, put forth by Arthur Okun,

that in the short run 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
Okuns Law predicts.
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The Short-Run Relationship Between Output and 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, dropping out of the
ranks of the unemployed and the labor force.
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The Size of the Multiplier

The value of the multiplier in reality is smaller than
the simple multiplier. We can now summarize why.
1. There are automatic stabilizers.
2. The interest rate and the crowding-out effect.
3. The effect of expansionary policy on the price
level.
4. The fact that firms hold excess capital and
excess labor.
5. There are inventories.
6. There are peoples 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.
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REVIEW TERMS AND CONCEPTS
accelerator effect
inputs
adjustment costs
inventory investment
animal spirits of
labor-intensive technology
entrepreneurs
life-cycle theory of consumption
capital-intensive technology
nominal wage rate
constrained supply of labor
nonlabor, or nonwage, income
desired, or optimal, level of
Okuns Law
inventories
permanent income
discouraged-worker effect
plant-and-equipment investment
excess capital
productivity, or labor productivity
excess labor
real wage rate

unconstrained supply of labor
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CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

PowerPoint Lectures for

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

PART VI FURTHER MACROECONOMICS ISSUES

Household and Firm

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

PART VI FURTHER MACROECONOMICS ISSUES

Household and Firm

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

life-cycle theory of consumption A theory of

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

FIGURE 31.1 Life-Cycle

permanent income The average level of a

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

A rise in the interest rate leads me to consume

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

Effect on labor supply

*If the substitution effect dominates.

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

Households consume less if they are constrained

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

The following factors affect household

Current and expected future real wage rates

Initial value of wealth

Current and expected future nonlabor income

Current and expected future tax rates and

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

FIGURE 31.2 Consumption Expenditures, 1970 I2007 IV

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

FIGURE 31.3 Housing Investment of the Household Sector, 1970 I2007 IV

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Households: Consumption and Labor Supply Decisions

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Firms: Investment and Employment Decisions

animal spirits of entrepreneurs A term coined

The Accelerator Effect

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Firms: Investment and Employment Decisions

inputs The goods and services that firms

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Firms: Investment and Employment Decisions

excess labor, excess capital Labor and capital

CHAPTER 31 Household and Firm Behavior in the Macroeconomy: A Further Look

Firms: Investment and Employment Decisions