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Principles of macroeconomics 10e by case fair oster ch16

PRINCIPLES OF

MACROECONOMICS

PART IV Further Macroeconomics Issues

TENTH

EDITION

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly
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PART IV Further Macroeconomics Issues
© 2012 Pearson Education, Inc. Publishing as Prentice Hall


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Household and Firm
Behavior in the
Macroeconomy:
A Further Look*

16
CHAPTER OUTLINE
Households: Consumption and Labor
Supply Decisions

PART IV Further Macroeconomics Issues

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

* This chapter is somewhat more advanced,
but it contains a lot of interesting information!

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Expectations and Animal Spirits
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
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.

PART IV Further Macroeconomics Issues

permanent income The average level of a person’s
expected future income stream.

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Households: Consumption and Labor Supply Decisions
The Life-Cycle Theory of Consumption

PART IV Further Macroeconomics Issues

 FIGURE 16.1
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.

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PART IV Further Macroeconomics Issues

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.

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PART IV Further Macroeconomics Issues

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.

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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Demographics and both legal and illegal immigration play a role in
determining the size of the labor force.
Behavior also plays a role. 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.

PART IV Further Macroeconomics Issues

The Wage Rate
A higher wage would lead to a larger quantity of labor
supplied—a larger workforce. This is called the substitution
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. This is the income effect of a wage rate increase.

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PART IV Further Macroeconomics Issues

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.

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PART IV Further Macroeconomics Issues

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.

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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Prices
nominal wage rate The wage rate in current dollars.

PART IV Further Macroeconomics Issues

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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Households: Consumption and Labor Supply Decisions
The Labor Supply Decision
Wealth and Nonlabor Income

PART IV Further Macroeconomics Issues

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.
nonlabor, or nonwage, income Any income received
from sources other than working—inheritances, interest,
dividends, transfer payments, and so on.
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.

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PART IV Further Macroeconomics Issues

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.

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PART IV Further Macroeconomics Issues

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.

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Households: Consumption and Labor Supply Decisions
Interest Rate Effects on Consumption
A rise in the interest rate leads you to consume less today and save
more. This effect is called the substitution effect.
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.

PART IV Further Macroeconomics Issues

Government Effects on Consumption and Labor Supply: Taxes and Transfers
TABLE 16.1 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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PART IV Further Macroeconomics Issues

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.

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PART IV Further Macroeconomics Issues

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.

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Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
How does a household respond when it is constrained from working
as much as it would like?
It consumes less.

PART IV Further Macroeconomics Issues

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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Households: Consumption and Labor Supply Decisions
A Possible Employment Constraint on Households
Keynesian Theory Revisited

PART IV Further Macroeconomics Issues

Recall the Keynesian theory that current income determines
current consumption.
Although consumption and labor supply decisions depend on
the real wage rate, if there is unemployment, income
depends on the employment decisions made by firms and not
on household decisions.
Developed during a period of unemployment, Keynesian
theory is considered to pertain to those periods.

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Households: Consumption and Labor Supply 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
PART IV Further Macroeconomics Issues

Interest rates
Current and expected future tax rates and transfer payments

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Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970

 FIGURE 16.2 Consumption Expenditures, 1970 I–2010 I

PART IV Further Macroeconomics Issues

Consumption

Over time, expenditures on services and nondurable
goods are “smoother” than expenditures on durable
goods.

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PART IV Further Macroeconomics Issues

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.

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PART IV Further Macroeconomics Issues

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.

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E C O N O M I C S I N PRACTI C E
Household Reactions to Winning the Lottery
The more nuanced theory of
consumption that we have
explored in this chapter makes
some predictions about what
households will do if they have a
sudden increase in wealth.

PART IV Further Macroeconomics Issues

Of course, such increases are
uncommon, but winning the
lottery is one such example.
A study by three economists,
Guido Imbens, Donald Rubin, and Bruce Sacerdote, of a large sample of
lottery winners found that winning reduced work hours by 11 percent and that
of the first half of lottery winnings received, 16 percent on average was saved.
Smith Prepares to Leave Office after Winning Lottery
The Baltimore Sun

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Households: Consumption and Labor Supply Decisions
The Household Sector Since 1970

Housing investment fell during the five
recessionary periods since 1970.
Like expenditures for durable goods,
expenditures for housing investment are
postponable.

PART IV Further Macroeconomics Issues

Housing Investment

 FIGURE 16.3 Housing Investment of the Household
Sector, 1970 I–2010 I

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