The Keynesian Theory of Consumption:
A Review
• Keynes suggested that consumption is a
positive function of income, and that highincome households consume a smaller
portion of their income than low-income
households.
• The average propensity to consume is
the portion of income households spend on
consumption.
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© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Life-Cycle Theory of Consumption
• The life-cycle theory of consumption is an
extension of Keynes's theory. It states that
households make lifetime consumption decisions
based on their expectations of lifetime income.
• People tend to consume
less than they earn during
their main working years,
and dissave during their
early and later years.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Life-Cycle Theory of Consumption
• Consumption decisions are likely to be
based on permanent income rather than on
current income.
• Permanent income is the average level of
one’s expected future income stream.
• Policy changes, like tax-rate changes, are
likely to have more of an effect on
household behavior if they are expected to
be permanent rather than temporary.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
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.
• Factors that determine the quantity of labor
supplied include the wage rate, prices,
wealth, and nonlabor income.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Labor Supply Decision
• An increase in the wage rate causes the
opportunity cost of leisure to rise, leading to a
larger labor supply—a larger labor force. This is
called the substitution effect of a wage rate
increase.
• On the other hand, a higher wage means that
people will spend some of it on leisure by working
less. This is the income effect of a wage rate
increase.
• Data suggests that the substitution effect prevails
over the income effect, so higher wages lead to an
increase in labor supply.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Labor Supply Decision
• Prices also play a major role in the labor
supply decision.
• The nominal wage rate is the wage rate in
current dollars.
• The real wage rate is the amount that the
nominal wage rate can buy in terms of
goods and services.
• Workers do not care about their nominal
wage—they care about the purchasing
power of this wage—the real wage rate.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Labor Supply Decision
• Wealth fluctuates over the life cycle.
• 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Interest Rate Effects on Consumption
• A rise in the interest rate increases the
reward to saving and lowers consumption.
This is the substitution effect of an interest
rate change.
• There is also an income effect of an
interest rate change. A fall in the interest
rate leads to a fall in nonlabor income and
consumption.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Interest Rate Effects on Consumption
• For households with positive wealth, the
income effect of an interest rate change
works in the opposite direction from the
substitution effect.
• On the other hand, if a household is a debtor,
a fall in the interest rate means a fall in
interest payments, so the income and
substitution effects work in the same
direction.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Government Effects on Consumption and
Labor Supply: Taxes and Transfers
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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
A Possible Employment
Constraint on Households
• The budget constraint, which separates
those bundles of goods that are available
to a household from those that are not, is
determined by income, wealth, and prices.
• When a household is constrained from
working as much as it would like, it
consumes less.
• The amount that a household would like to
work at the current wage rate if it could find
the work is called the unconstrained
supply of labor.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Keynesian Theory Revisited
• It is incorrect to think consumption depends
only on income, at least when there is full
employment.
• But if there is unemployment, the level of
income depends exclusively on the
employment decisions made by firms.
• To the extent that Keynes emphasized the
relationship between consumption and
income, Keynesian theory is considered to
pertain to periods of unemployment.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
A Summary of Household Behavior
• Factors that affect household consumption
and labor supply decisions include:
• current and expected future real wage rates
• the initial value of wealth
• current and expected future nonlabor income
• interest rates
• current and expected future tax rates and
transfer payments
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Consumption Expenditures,
1970 I – 2000 II
• Expenditures on services and nondurable goods are “smoother” over
time than expenditures on durable goods.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Housing Investment of the Household
Sector, 1970 I – 2000 II
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Labor-Force Participation Rate for Men 25 to 54, Women
25 to 54, and All Others 16 and Over, 1970 I – 2000 II
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Firms: Investment and
Employment Decisions
• Inputs are the goods and services that
firms purchase and turn into output.
• There are two ways that firms can add to
their stock of capital:
• Plant-and-equipment investment refers to
purchases 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Employment Decisions
• 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.
• The demand for new capital, or planned
investment spending, which is partly
determined by the interest rate, is as
important as the demand for labor.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Employment Decisions
• The decision of how much output to
produce requires a decision concerning the
method of production, or technology.
• A profit-maximizing firm chooses the
technology that is most efficient—the one
that minimizes the cost of production.
• The most efficient technology depends on
the relative prices of capital and labor.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Employment Decisions
• A labor-intensive technology is a
production technique that uses a large
amount of labor relative to capital.
• A capital-intensive technology is a
production technique that uses a large
amount of capital relative to labor.
• The relative impact of an expansion of
output on employment and on investment
demand depends on the wage rate and the
cost of capital.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Expectations and Animal Spirits
• Investment decisions require looking into
the future and forming expectations about it.
• Expectations are always made with
imperfect information.
• Keynes concludes that much investment
activity depends on psychology and on what
he calls the animal spirits of entrepreneurs,
which help to make investment a volatile
component of GDP.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Accelerator Effect
• The accelerator effect is the tendency for
investment to increase when aggregate
output increases and decrease when
aggregate output decreases, accelerating
the growth or decline of output.
• If aggregate output (income) (Y) is rising,
investment will increase even though the
level of Y may be low, further accelerating
the growth of output.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Excess Labor and
Excess Capital Effects
• Excess labor and excess capital are
labor and capital that are not needed to
produce the firm’s current level of output.
• Decreasing its workforce and capital stock
quickly can be costly for a firm.
• Adjustment costs are 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Inventory Investment
Stock of inventories (end of period) = Stock of inventories (beginning of
period) + Production – Sales
• Inventories are counted as part of a firm’s
capital stock.
• The desired, or optimal, level of
inventories is 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).
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Inventory Investment
• There is a trade-off between holding
inventories and changing production levels.
• Because of adjustment costs, a firm is likely
to smooth its production path relative to its
sales path. Production should fluctuate less
than sales, with changes in inventories
absorbing the difference each period.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Inventory Investment
• 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.
• A firm’s planned production path depends
on the level of its expected future sales
path.
• Future sales expectations are likely to have
an important effect on current production.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
A Summary of Firm Behavior
• The following factors affect firms’
investment and employment decisions:
• the wage rate and the cost of capital.
• firms’ expectations of future output.
• the amount of excess labor and excess capital
on hand.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
A Summary of Firm Behavior
• The most important points to remember
about the relationship between 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Plant and Equipment Investment of the
Firm Sector, 1970 I – 2000 II
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Employment in the Firm Sector,
1970 I – 2000 II
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Inventory Investment of the Firm Sector and
the Inventory/Sales Ratio, 1970 I – 2000 II
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Productivity and the Business Cycle
• Productivity, or labor productivity, is
defined as output per worker hour (Y/H);
the amount of output produced by an
average worker in 1 hour.
• Productivity tends to rise during
expansions and fall during contractions.
• During expansions, output rises by a larger
percentage than employment, and the ratio
of output to workers rises.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
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 tends to
rise during expansions
and decline during
contractions.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Productivity in the Long Run
• Theories of (long-run) economic growth focus on
productivity, as measured by output per worker, or
GDP per capita.
• Using productivity figures to diagnose the
economy in the short run can be misleading.
• The tendency of firms to hold excess labor and
capital, and its implications for the measurement of
productivity throughout the business cycle, has
nothing to do with the economy’s long-run
potential to produce output.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Relationship Between
Output and Unemployment
• Okun’s Law is a theory put forth by Arthur
Okun, that the unemployment rate
decreases about one 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Relationship Between
Output and Unemployment
•
There are three “slippages” that combine
to make the change in the unemployment
rate less than the percentage change in
output in the short run:
1. When output rises by 1 percent, the number of
jobs does not tend to rise by 1 percent in the
short run.
2. There are more jobs than there are people
employed. Some of the jobs are filled by
people who already have one job.
3. Discouraged workers move back into the labor
force.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Size of the Multiplier
• There are a number of factors we have
mentioned that cause the size of the
multiplier to decrease. For example:
• Automatic stabilizers: When the economy
expands and income increases, the amount of
taxes collected increases, offsetting some of
the expansion.
• The interest rate: All else the same, an
increase in government spending causes the
interest rate to increase, crowding out
consumption and investment expenditures.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Size of the Multiplier
• There are a number of factors we have
mentioned that cause the size of the
multiplier to decrease. For example:
• The response of the price level: Expansionary
policy leads to an increase in the price level,
which reduces the multiplier, particularly when
the economy is on the steep part of the AS
curve.
• There are excess capital and excess labor:
Output can increase by putting excess labor
and capital back to work (less investment).
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Size of the Multiplier
• There are a number of factors we have
mentioned that cause the size of the
multiplier to decrease. For example:
• There are inventories: To the extent that firms
draw down their inventories in the short run in
response to an increase in demand, output
does not respond as quickly to demand
changes.
• The life-cycle story and expectations: The
multiplier effects for policy changes perceived
to be temporary are smaller.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Size of the Multiplier
• In practice, the multiplier probably has a
value of around 1.4, at its peak. For
example, if government spending rises by
$1 billion, then GDP rises by about $1.4
billion.
• The response of the economy to a change
in monetary or fiscal policy is not likely to
be large and quick and, in the final
analysis, the effects are much smaller than
the simple multiplier would lead one to
believe.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair