We will return to exchange rates and banking later in term:
Applications lecture on eurozone planned.
Consumption is a Large Part of GDP
Consumption and Growth Move Together
What isn’t Spent is Saved…
Marginal Propensity to Consume (MPC)
Fraction of an Increase in Income Consumed
The Multiplier
Simple consumption function (with \(b\) as MPC): \[
C = A + bY.
\]
Average propensity to consume: \[
APC = \frac{C}{Y} = \frac{A}{Y} + b.
\]
As \(Y\) gets large, APC=MPC.
Recall: \[
Y = C+I+G.
\]
Hence: \[
Y = A + bY + I + G.
\]
Rearranging: \[
Y = \frac{A + I + G}{1-b}.
\]
Motivation for multiplier: If \(G\uparrow\), \(\Delta Y > \Delta G\).
Permanent Income — The Alternative
The multiplier arises out of Keynesian current consumption focus.
But don’t we consume based on future income?
Simplify to two periods: Today/tomorrow, young/old, etc.
Income in each period: \(Y(1)\) and \(Y(2)\), and consumption decisions \(C(1)\) and \(C(2)\).
No wealth to begin with, cannot take any out either.
Bank pays interest \(r\) on any savings such that at beginning of period 2 person has: \[
(1+r)\left[Y(1) - C(1)\right].
\]
Hence with income from second period, individual can spend: \[
Y(2) + (1+r)\left[Y(1) - C(1)\right].
\]
Given nothing can be left behind, then: \[
C(2) = Y(2) + (1+r)\left[Y(1) - C(1)\right].
\]
To get budget constraint need to rearrange so consumption function of income: \[
(1+r)C(1) + C(2) = (1+r)Y(1) + Y(2)
\]
Convention is to write in terms of period one consumption so divide by \((1+r)\): \[
C(1) + \frac{C(2)}{1+r} = Y(1) + \frac{Y(1)}{1+r}.
\]
Dividing by \(1+r\) discounts a number to its present value, today’s money.
This is lifetime, or inter-temporal budget constraint.
Inter-Temporal Budget Constraint, Plotted
Inter-Temporal Preferences
Inter-Temporal Optimisation
Response to Increase in Current Income
Response to Increase in Future Income
But Current Income Matters… Due to Borrowing Constraints?
Deregulation in the 1980s Allowed People to Borrow…
MPC Higher if Financial Constraints Bind
Interest Rates Redistribute from Spenders to Savers
Savings Ratios Do Not Include Capital Gains
Lifecycle Effects, and the Impact of Uncertainty
Although Bequests and Uncertainty Keep OAP Savings High
Investment More Volatile than Income
Much More in Places…
Investment and the Optimal Capital Stock
Cost of Capital is Opportunity Cost Regardless of Funding Source
Investment Sensitive to Interest Rates
Investment also Affected by Technology
Investment and the Stock Market
Most firms fund investment via internal resources: Usually shareholder capital.
Should thus expect link between stock market and investment?
Tobin’s q theory:
If stock mkt value of firm \(>\) replacement cost of firm’s capital, invest!
Can essentially create another identical company and hence make more return.
Ratio between firm stock mkt value and replacement cost of capital is `Tobin’s q’.
Related idea: Invest if rate of return on capital exceeds cost of capital: \[
\text{Rate of return} = \frac{\text{Profits}}{\text{Replacement cost of capital}}.
\]
Cost of capital: Shareholders’ required rate of return: \[
\text{Cost of capital} = \frac{\text{Profits}}{\text{Stock market value of firm}}.
\]
Ratio of ratios: \[
\frac{\text{Profits}}{\text{Replacement cost of capital}}\left/\frac{\text{Profits}}{\text{Stock market value of firm}}\right. \\\hspace{5cm}= \frac{\text{Stock market value of firm}}{\text{Replacement cost of capital}} = q.
\]
Hence if \(q>1\) then rate of return \(>\) cost of capital, hence invest.
Tobin’s q Theory of Investment……
???
The IS Curve
IS-LM model: Interaction of financial and non-financial sectors…
IS is investment-savings aspect of model.
Builds on Keynesian model of consumption and concept of planned expenditure: \[
PE = C + I + G = A + bY + I + G.
\]
If actual expenditure equals planned expenditure then \(PE=Y\) so: \[
Y = A + bY + I + G \qquad \Longrightarrow \qquad Y = \frac{A+I+G}{1-b}.
\]
Again shows multiplier effect of \(G\) and \(I\).
But planned and actual expenditure will not always coincide…
The Keynesian Cross Diagram
The Multiplier Effect: Increase \(G\) or \(I\)…
Larger the MPC, Larger the Multiplier…
What if Interest Rates Change?
The IS Curve
Concluding
Today: Chapter 10, consumption and investment.
Lifetime cycle, permanent income, investment and capital, IS curve.
For week 8 classes:
Assignment on blackboard:
Look at your home LSOA: .
Analyse in context of local and nationwide trends.
This week: the FTSE has hit new heights this week!
