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A set of slides from the macroeconomics: a european perspective textbook by blanchard, amighini, and giavazzi. The slides discuss the role of expectations and wealth in determining consumption and investment. The authors argue that consumption depends not only on current income but also on total wealth and expectations of future income. Similarly, investment depends not only on current profits but also on expected future profits. The slides also explore the intertemporal budget constraint and the relationship between consumption and saving.
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Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.4^ The theory of consumption was developed by MiltonFriedman in the 1950s, who called it the
permanent
income theory of consumption
, and by Franco
Modigliani, who called it the
life cycle theory of
The permanent income theory of consumption consumption.^ In words:^ Consumption is an increasing function of total wealth,and also an increasing function of after-tax labourincome. Total wealth is the sum of non-human wealth –financial wealth plus housing wealth – and humanwealth – the present value of expected after-tax income.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.
Intertemporal choice
, future (expected) real income y 1
. Saving 2
s^ (or
2
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
curve^
represents
all^ the
combinations
of^ current
and^ future
consumption among which the consumer is indifferent, that is those thatprovide the same
utility level
utility
function^
U(c, c) assigning a value to each basket (c^12
, c). 12
-^ Convex indifference curves mean that consumers prefer a morebalanced consumption path over time (relatively close levels of c
1
Intertemporal preferences
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.
c^2
cy^1 y^2
1
2
1+r
To represent the intertemporalbudget constraint graphically,rewrite it as:^ c= (1+r) y^2
+ y- (1+r) c 12
. 1
Given y^1
and y, c 2
is a linear 2 function of c
with a negative 1 slope given by -
(1+r). The^ optimal
combination
of
current and future consumptionis the point along the budgetconstraint
that^ lies
on^ the Intertemporal optimization highest indifference curve, i.e.a point of tangency.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.
c^2
cy^1 y^2
1
2
1+r^ y'^1
An increase in currentincome increasesconsumption but alsosaving (
∆^ c<^ ∆^1
y).^1 Change in current income
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.11^ An increase in expectedfuture income increasescurrent consumption(reducing saving).
c^2
cy^1 y^2
1
2
1+r
y'^2
Change in expected income
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.
To summarize:
-^ Consumers prefer more balanced consumptions paths over time toextreme variations (
consumption smoothing
). By adjusting saving
(and^ borrowing)
they^
can^ compensate
income
fluctuations
and
maintain a more stable consumption path. Then consumption is likelyto respond less than one-for-one to fluctuations in current income.•^ Permanent
changes
in^ income
affect^
consumption
more^
than
temporary changes
-^ Expectations
about
future
disposable
income
or^ economic
conditions (consumer confidence) affect current consumption. Thenconsumption may move even if current income does not change.• Changes in non-human
wealth
may also affect consumption.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Current vs expected income: liquidity constraints Slide16.14 Why, then, does consumption reacts so much to current income? • Many consumers (especially those with low income, no wealth and littlemargin for^ saving)
would^
often^ depend
on^ credit
to^ smooth
their
consumption in the face of a temporary fall in income or to adjust tohigher expectations of future income.• But they may face
credit or liquidity constraints
, that is, they may
find^ it^
difficult^
to^ obtain
credit^
to^ finance
consumption.
Then^
their
consumption cannot exceed their current income:
c≤^ y.^11
dissave
or^ borrow
to^ avoid
an^ excessive
decrease
in
consumption).• Some consumers may also find it difficult to plan forming rationalexpectations and taking correctly into account the future.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.
The present value of expected profits The^ present value of expected profits
depends on
how long the machine/unit of capital will last.The^
depreciation
rate ,
δ,^ measures
how
much
usefulness the machine loses from one year to thenext. (reasonable values for
δ^ are between 4% and 15% for machines, and between 2% and 4% for buildings and factories)
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
Slide16.17^ The present value, at year
t , of expected profit in year
t+1^ generated by
the extra machine equals:The present value, at year
t , of expected profit in year
t+2^ equals:
1^ e Π t^1 + r^^ ) (^1) (+ t^ e te t rr (^) t
2 ) (^1) ( ) (^1) )( 1 (^1 1) (
Π− ++
δ
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
e ( ) ( )+ t^
t I^ I V =^
Π
The Investment Decision
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1Edition, © Pearson Education Limited 2010
e^
e 1 2 t^
t^
t
+^
Π^ = Π
=^
Π... = e^
e 1 2 t^
t^
t
r^
r^
r
+^ =^ =^ +
... =
e ( )^
t V^ t rt
Π^ δ Π^ =
