Principles of Macroeconomics

Twelfth Edition

Chapter 15
Household and Firm
Behavior in the
Macroeconomy: A
Further Look

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Chapter Outline and Learning
Objectives (1 of 2)
15.1 Households: Consumption and Labor Supply
Decisions
• Describe factors that affect household consumption and labor supply
decisions.

15.2 Firms: Investment and Employment Decisions

• Describe factors that affect the investment and employment decisions
of firms.

15.3 Productivity and the Business Cycle

• Explain why productivity is procyclical.

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Chapter Outline and Learning
Objectives (2 of 2)
15.4 The Short-Run Relationship between Output and
Unemployment
• Describe the short-run relationship between output and
unemployment.

15.5 The Size of the Multiplier

• Identify factors that affect multiplier size.

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Households: Consumption and Labor
Supply Decisions
• In Chapters 23 through 29, we assumed that household
consumption depends only on income and that firms’
planned investment depends only on the interest rate.
• In this chapter, we present a more realistic picture of the
influences on households’ consumption and labor supply
decisions and on firms’ investment and employment
decisions.

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

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FIGURE 15.1 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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The Labor Supply Decision (1 of 5)
• Demographics and both legal and illegal immigration play
roles in determining the size of the labor force.
• Behavior also plays a role. Households make decisions
about labor supply in order to earn income to pay for their
consumption.

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The Labor Supply Decision (2 of 5)
The Wage Rate
• The substitution effect of a wage rate increase: A higher
wage leads to a larger quantity of labor supplied.
• The income effect of a wage rate increase: Because leisure
is a normal good, people with higher income will spend some
of it on leisure by working less.

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The Labor Supply Decision (3 of 5)
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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The Labor Supply Decision (4 of 5)
Wealth and Nonlabor Income
• The more wealth a household has, the more it will
consume both now and in the future, holding everything
else constant (including the stage in the life cycle).
• 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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The Labor Supply Decision (5 of 5)
Interest Rate Effects on Consumption
• Substitution effect: A rise in the interest rate leads
you to consume less today and save more.
• Income effect: 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 15.1 The Effects of Government on Household
Consumption and Labor Supply
Income Tax Income Tax Transfer Transfer
Rates Rates Payments Payments
Increase Decrease Increase Decrease
Effect on
Negative Positive Positive Negative
consumption
Effect on
Negative* Positive* Negative Positive
labor supply

* If the substitution effect dominates.

Note: The effects are larger if they are expected to be permanent instead of temporary.

Transfer payments are payments such as Social Security benefits, veterans’

benefits, and welfare benefits.

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A Possible Employment Constraint on
Households (1 of 2)
• 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 (2 of 2)
Keynesian Theory Revisited
• Recall the Keynesian theory that current income
determines current consumption.
• Both consumption and labor supply decisions depend on
the real wage rate, but if there is unemployment, it is
income, not the wage rate, that affects consumption.
• For this reason, Keynesian theory is considered to pertain
to periods of unemployment.

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A Summary of Household Behavior
• 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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 The Household Sector since 1970
FIGURE 15.2 Consumption
Expenditures, 1970 I–2014 IV

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

MyEconLab Real-time data

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FIGURE 15.3 Housing Investment of the Household Sector,
1970 I–2014 IV

MyEconLab Real-time data

• Housing investment fell during the five recessionary periods since 1970.

• Like expenditures for durable goods, expenditures for housing investment are
postponable.
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ECONOMICS IN PRACTICE
Measuring Housing Price Changes
• Karl Case, working with Robert Shiller,
a behavioral finance economist,
developed a housing price index that
solves the problem that houses are all
different.

• The Case-Shiller index looks only at

houses that have sold multiple times
and asks the question: How much does
an identical house sell for now versus
in the past?

THINKING PRACTICALLY

1. Who, other than macroeconomists, might be interested in the Case-Shiller index?

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FIGURE 15.4 Labor Force Participation Rates for Men 25 to 54,
Women 25 to 54, and All Others 16 and Over, 1970 I–2014 IV

MyEconLab Real-time data

• 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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Excess Labor and Excess Capital
Effects
• excess labor, excess capital Labor and capital that are
not needed to produce the firm’s 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 (1 of 2)
• inventory investment The change in the stock of
inventories.

The Role of Inventories

stock of inventories  end of period   stock of inventories  begining of period   production -sales

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Inventory Investment (2 of 2)
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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A Summary of Firm Behavior
• These factors affect firms’ investment and employment
decisions:
• Firms’ expectations of future output
• Wage rate and cost of capital
• Amount of excess labor and excess capital on hand
• Important points about the relationship among production,
sales, and inventory investment:
• 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.

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The Firm Sector since 1970
FIGURE 15.5 Plant-and-Equipment Investment of the Firm Sector,
1970 I–2014 IV

Overall, plant-and-equipment investment declined in the five recessionary periods

since 1970.

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FIGURE 15.6 Employment in the Firm Sector, 1970 I–2014 IV

Growth in employment was generally negative in the five recessions the U.S.
economy has experienced since 1970.

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FIGURE 15.7 Inventory Investment of the Firm Sector and the
Inventory-to-Sales Ratio, 1970 I–2014 IV

MyEconLab Real-time data

• The inventory/sales ratio is the ratio of the firm sector’s stock of inventories
to the level of sales.

• Inventory investment is volatile.

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Productivity and the Business Cycle
• productivity, or labor productivity Output per worker
hour.
• Productivity fluctuates over the business cycle, tending to
rise during expansions and fall during contractions.

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FIGURE 15.8 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 output-to-labor ratio) tends to rise during

expansionary periods and decline during contractionary periods.

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The Short-Run Relationship between
Output and Unemployment (1 of 2)
• Okun’s Law The theory, put forth by Arthur Okun, that in
the short run the unemployment rate decreases about 1
percentage point for every 3% 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.
• If E denotes the number of people employed, L the number
of people in the labor force, and u the unemployment rate,
then:
u 1 E/L

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The Short-Run Relationship between
Output and Unemployment (2 of 2)
• 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 (1 of 2)
• Effects that decrease the size of the multiplier:
1. Automatic stabilizers
2. The interest rate
3. The response of the price level
4. Excess capital and excess labor
5. Inventories
6. People’s expectations about the future

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The Size of the Multiplier (2 of 2)
The Size of the Multiplier in Practice
• In practice, the multiplier probably has a value of around
2.0.
• The size of the multiplier also depends on how long ago the
spending increase began.

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REVIEW TERMS AND CONCEPTS
• accelerator effect
• adjustment costs
• animal spirits of entrepreneurs
• constrained supply of labor
• desired, or optimal, level of inventories
• discouraged-worker effect
• excess labor, excess capital
• inventory investment
• life-cycle theory of consumption
• nominal wage rate
• nonlabor, or nonwage, income
• Okun’s Law
• permanent income
• productivity, or labor productivity
• real wage rate
• unconstrained supply of labor

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