John F. Kennedy
Household and Firm Behavior in the Macroeconomy: A Further Look
(Part C)
by
Charles Lamson
 |
Interest Rate Effects on Consumption
Recall from previous posts that the interest rate affects a firm's investment decision. A higher interest rate leads to a lower level of planned investment, and vice versa. This was a key link between the money market and the goods market, and it was the channel through which monetary policy had an impact on planned aggregate expenditure. We can now expand on this link: The interest rate also affects household behavior. Consider the effect of a fall in the interest rate on consumption. The fall in the interest rate lowers the reward to saving. If the interest rate falls from 10 percent to 5 percent, I earn 5 cents instead of 10 cents per year on every dollar saved. This means that the opportunity cost of spending a dollar today (instead of saving it and consuming it plus the interest income a year from now) has fallen. I will substitute toward current consumption and away from the future consumption when the interest rate falls: I consume more today and save less. A rise in the interest rate leads me 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. This is a decrease in its nonlabor income, which will have a negative effect on consumption. For households with positive wealth, the income effect works in the opposite direction from the substitution effect. On the other hand, if a household is a debtor and is paying interest on its debt, a fall in the interest rate leads to a fall in interest payments. The household is better off in this case and will consume more. In this case the income and substitution effects work in the same direction. The total household sector of the United States has positive wealth, and so in the aggregate the income and substitution effects work in the opposite direction.  On balance, the data suggest that the substitution effect dominates the income effect, so that the interest rate has a negative net effect on consumption (Case & Fair, 2004).
Government Effects on Consumption and Labor Supply: Taxes and Transfers The government influences household behavior mainly through income tax rates and transfer payments. When the government raises income tax rates, after-tax real wages decrease, lowering consumption. When the government lowers income tax rates, after-tax real wages increase, raising consumption. A change in income tax rates also affects labor supply. If the substitution effect dominates, as we are generally assuming, then an increase in income tax rates, which lowers after-tax wages, will lower labor supply. A decrease in income tax rates will increase labor supply. Transfer payments are payments such as Social Security benefits, veterans benefits, and welfare benefits. An increase in transfer payments is an increase in non-labor income, which we have seen has a positive effect on consumption and a negative effect on labor supply. Increases in transfer payments thus increase consumption and decrease labor supply, while decreases in transfer payments decrease consumption and increase labor supply. Table 1 summarizes these results. TABLE 1   A Possible Employment Constraint on Households Our discussion of the labor supply decision has so far proceeded as if households were free to choose how much to work each. If a member of our household decides to work an additional 5 hours a week at the current wage rate, we have assumed the person can work 5 hours more---that work is available. If someone who has not been working decides to work at the current wage rate, we have assumed that the person can find a job. There are times when these assumptions do not hold. The Great Depression, when unemployment rates reached 25 percent of the labor force, led to the birth of macroeconomics in the 1930s. All households face a budget constraint regardless of the state of the economy. This budget constraint, which separates those bundles of goods that are available to our household from those that are not, is determined by income, wealth, and prices. When there is unemployment, some households feel an additional constraint on their behavior. Some people may want to work 40 hours per week in the current wage rates but can find only part-time work. Others may not find work at all. How does a household respond when it is constrained from working as much as it would like? It consumes less. If your current wage rate is $10 per hour and you normally work 40 hours a week, your normal income from wages is $400 per week. If your average tax rate is 20 percent, your after-tax wage income is $320 per week. You are likely to spend much of this income during the week. If you are prevented from working, this income will not be available to you, and you will have less to spend.  You will spend something, of course. You may receive some form of nonlabor income, and you may have assets, such as savings deposits or stocks and bonds, that can be withdrawn or sold. You may also be able to borrow during your period of unemployment. Even though you will spend something during the week, it is almost certain that you will spend less than you would have if you had your usual income of $320 in after-tax wages. Households consume less if they are constrained from working. A household constrained from working as much as it would like at the current wage rate faces a different decision from the decision facing a household that can work as much as it wants. The work decision of the former household is, in effect, forced on it. The household works as much as it can---a certain number of hours per week or perhaps not at all---but this amount is less than their household would choose to work at the current wage rate if it could find more work. The amount that a household would like to work at the current wage rate if it could find the work is called its unconstrained supply of labor. The amount that the household actually works in a given period at current wage rates is called its constrained supply of labor. Household constrained supply of labor is not a variable over which it has any control. The amount of labor the household supplies is imposed on it from the outside by the workings of the economy. However, the household's consumption is under its control. We have just seen that the less a household works---that is, the smaller the household's constrained supply of labor is---the lower its consumption. Constraints on the supply of labor are an important determinant of consumption when there is unemployment.  Keynesian Theory Revisited Recall the Keynesian theory (from part 151) that current income determines current consumption. We now know the consumption decision is made jointly with the labor supply decision and the two depend on the real wage rate. It is incorrect to think consumption depends only on income, at least when there is full employment. However, if there is unemployment, Keynes is closer to being correct because income is not determined by households. When there is unemployment, the level of income (at least workers' income) depends exclusively on the employment decisions made by firms. There are unemployed workers who are willing to work at the current wage rate, and their income is in effect determined by firms' hiring decisions. This income affects current consumption, which is consistent with Keynes's theory. This is one of the reasons Keynesian theory is considered to pertain to periods of unemployment. It was, of course, precisely during such a period that the theory was developed. Summary of Household Behavior This completes our discussion of household behavior in the macroeconomy. Household consumption depends on more than current income. Households determine consumption and labor supply simultaneously, and they look ahead in making their decisions. The following factors affect household consumption and labor supply decisions:
If households are constrained in their labor supply decisions, income is directly determined by firms' hiring decisions. In this case, we can say (in the traditional, Keynesian way) that "income" affects consumption. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 612-614* end |
No comments:
Post a Comment