DE LAS MUJERES
3.3. PRODUCTOS O SERVICIOS ESTRELLA
On October 19, 1987, stock prices took their biggest-ever one-day plunge. The Stan dard and Poor's index of 500 stocks dropped 20°/o that day, after having fallen by 16°/o from the market's peak in August of the same year. About $1 trillion of finan cial wealth was eliminated by the decline in stock prices on that single day.
Stock prices in the United States soared during the 1990s, especially during the second half of the decade, but then tumbled sharply early in the first year of the new century. Stock prices continued to fall for several years, and stockholders lost wealth of about $5 trillion, an amount equal to about half of a year's GDP. After rising from 2003 to 2007, stock prices plunged during the financial crisis of 2008, with stocks losing 48°/o of their value in real terms. By the first quarter of 2009, real
stock prices were at their lowest level since 1995.
What are the macroeconomic effects of such booms and busts in stock prices?
We have emphasized two major macroeconomic channels for stock prices: a wealth effect on consumption and an effect on capital investment through Tobin's q. Let's see how each of those effects worked after the stock market crash of 1987, the increase in stock values in the 1990s, the decline in stock market wealth in the early 2000s, and the financial crisis of 2008.
The
wealth effect
on consumption arises because stocks are a component of households' financial assets. Because a stock market boom makes households better off financially, they should respond by consuming more; and likewise, abust in the stock market reduces household wealth and should reduce consump tion. To show how consumption and stock prices are related, Fig. 4.11 plots the value of the S&P 500 index, adjusted for inflation, along with the ratio of con
sumption spending to GDP.
Consumption and the 1 987 Crash
We would expect that following the 1987 stock market crash, consumers would reduce spending, but the decline in consumption should have been much smaller than the $1 trillion decline in wealth, because consumers would spread the effects
4.1 1
Real U.S. stock prices and the ratio of
consumption to GDP, 1987-2009
The graph shows the
values of the real (infla tion-adjusted) S&P 500, which covers a broad
cross-section of U.S. cor porations, and the ratio
of consumption spending to GDP from 1987 to the first quarter of 2009. The variables move together in some episodes and in opposite directions in
other episodes.
Source: S&P 500 from Yahoo
finance Web site, finance.yahoo.
com; real S&P 500 calculated as
S&P 500 divided by GDP deflator; GDP deflator, con
sumption spending, and GDP from St. Louis Fed Web site at research.stlouisfed.orglfred2.
Chapter 4 Consumption, Savi ng, and I nvestment 1 39
g 1 800 0.71
�
0
ll') � � CJ'J ... 0 "(U 1 600 QJ 0.70 = 0 � •...C ... � 1 400 0.69 s fi:J = = 0 u 1 200 Ratio of consumption to GDP 0.68 C) (right sea I e) 1 000 800 600 400 Real S&P 500 (left scale) 0.67 0.66 0.65 0.64 200 0.63 0 0.62 1 987 1 989 1 99 1 1 993 1 995 1 997 1 999 2001 2003 2005 2007 2009 Year 0 •...C ... t";$ �of their losses over a long period of time by reducing planned future consumption as well as current consumption. If consumers spread changes in their wealth over 25 years, then we might guess that current consumption spending would decline by about $40 billion (assuming the real interest rate is near zero). However, con
sumers might also worry that the stock market crash would lead to a recession, so they might cut consumption further; such a scenario suggests that consumption should decline by more than $40 billion. However, economists who estimated the actual decline in consumption suggest that it fell less than $40 billion.15 Why did consumption decline less than economic theory suggests? Perhaps the reason is that the rise in stock prices had been very recent stock prices had risen 39°/o in the 8 months preceding the crash. Because the increase in stock prices occurred so rapidly, it is possible that by August 1987, stockholders had not yet fully adjusted their consumption to reflect the higher level of wealth. Thus, when the market fell, consumption did not have to decline by very much to fall back into line with wealth.16
15See C. Alan Garner, "Has the Stock Market Crash Reduced Consumer Spending?" Economic Review, Federal Reserve Bank of Kansas City, April 1988, pp. 3-6, and David Runkle, "Why No Crunch from the Crash?" Quarterly Review, Federal Reserve Bank of Minneapolis, Winter 1988, pp. 2-7.
16In "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, June 2001, pp. 815-849, Martin Lettau and Sydney Ludvigson noted that, prior to the crash, aggregate
consumption was unusually low relative to stock market wealth. Their analysis indicates that this behavior reflected consumers' expectations of a decline in the stock market.
1 40 Part 2 Long-Run Economic Performance
Consumption and the Rise in Stock Market Wealth in the 1 990s
The U.S. stock market enjoyed tremendous growth during the 1990s. The S&P 500 index more than tripled in real terms by the end of the decade. Our theory predicts that such gains in stock market wealth should be associated with increased con sumption spending.
However, contrary to our theory that an increase in wealth should increase con sumption, consumption does not appear to have been closely correlated with stock prices in the 1990s. Research by Jonathan Parker of Northwestern University shows that there has been a long-run increase in the ratio of consumption to GDP that began in 1979.17 He concludes that no more than one-fifth of the increase in the ratio of con sumption to GDP in the 1980s and 1990s resulted from increased wealth associated with the stock market boom. And in Fig. 4.11, we can see that stock prices increased sig nificantly from 1995 to 1998, yet consumption declined relative to GDP in that period.
Consumption and the Decline in Stock Prices in the Early 2000s
Following the peak of the stock market in early 2000, stock prices declined for three years, erasing about $5 trillion in wealth. Our theory suggests that consumers should respond by reducing their consumption spending. Yet Fig. 4.11 shows that, in fact, consumption spending increased significantly relative to GDP during that period, rising from 67°/o of GDP in 1999 to 70°/o in 2002. Several reasons may explain why consumption did not decline after stock prices fell: (1) the reduction in people's wealth is spread throughout their lifetimes, so there is not a large immediate impact on consumption; (2) at the same time stock prices declined, home prices rose, so many people who lost wealth in the stock market gained it back in real estate; and
(3) people may have just viewed their gains in the late 1990s as "paper profits" that were lost in the early 2000s, so neither the gains nor the losses affected consumption.
Investment and the Declines in the Stock Market in the 2000s
As we have seen in Fig. 4.11, the stock market fell precipitously in 2000 and 2008. The large declines in the stock market led to large declines in Tobin's q, the ratio of the market value of firms to the replacement cost of their capital, as you can see in Figure 4.7 in "In Touch with Data and Research: Investment and the Stock Market," p. 132. This figure also shows very sharp declines in real investment beginning shortly after the stock market and Tobin's q began to fall in 2000 and again in 2008. The slight delay in the fall in investment, relative to the fall in the stock market, reflects the lags in the process of making investment decisions, planning capital for mation, and implementing the plans. But despite these lags, the declines in invest ment following large declines in the stock market are quite evident.
The Financial Crisis of 2008
During the financial crisis of 2008, stock prices plunged rapidly. In the six months from August 2008 to February 2009, U.S. stock prices declined in nominal terms by 43°/o, one of the fastest declines in stock prices on record. Investors feared that a
depression was possible because of a meltdown in the financial sector, which had taken excessive risks, especially in real-estate markets. The recession that had
17"Spendthrift in America? On Two Decades of Decline in the U.S. Saving Rate," in B. Bernanke and
Chapter 4 Consumption, Savi ng, and I nvestment 1 41
begun in December 2007 became much worse, and the unemployment rate increased dramatically. In this case, unlike the episode in the early 2000s, home prices also declined, and the simultaneous decline in housing prices and stock values translated into a nearly 20°/o decline in household net wealth, which fell from $62.6 trillion at the end of 2007 to $50.4 trillion by the end of March 2009. Yet the ratio of consumption to GDP only declined about 1 percentage point in 2008, as
Fig. 4.11 shows, and then it rebounded in early 2009.
C H A PT E R S U MMA RY
1. Because saving equals income minus consumption, a household's decisions about how much to consume and how much to save are really the same decision. Individuals and households save because they value both future consumption and current consumption; for the same amount of income, an increase in current saving reduces current consumption but increases the amount that the individual or household will be able to consume in the future.
2. For an individual or household, an increase in current
income raises both desired consumption and desired saving. Analogously, at the national level, an increase in current output raises both desired consumption and desired national saving. At both the household and national levels, an increase in expected future income or in wealth raises desired consumption; however, because these changes raise desired consumption without affecting current income or output, they cause
desired saving to fall.
3. An increase in the real interest rate has two poten tially offsetting effects on saving. First, a higher real interest rate increases the price of current consump tion relative to future consumption (each unit of cur rent consumption costs 1 + r units of forgone future
consumption). In response to the increased relative price of current consumption, people substitute future consumption for current consumption by saving more today. This tendency to increase saving in response to an increase in the relative price of cur rent consumption is called the substitution effect of the real interest rate on saving. Second, a higher real interest rate increases the wealth of savers by increas ing the interest payments they receive, while reduc ing the wealth of borrowers by increasing the amount of interest they must pay. By making savers wealthier, an increase in the real interest rate leads savers to consume more and reduce their saving; however, because it makes borrowers poorer, an increase in the real interest rate causes borrowers to reduce their consumption and increase their saving. The change in current consumption that results
because a consumer is made richer or poorer by an increase in the real interest rate is called the income effect of the real interest rate on saving.
For a saver, the substitution effect of an increase in the real interest rate (which tends to boost saving) and the income effect (which tends to reduce saving) work in opposite directions, so that the overall effect is ambiguous. For a borrower, both the substitution effect and the income effect of a higher real interest rate act to increase saving. Overall, empirical studies suggest that an increase in the real interest rate increases desired national saving and reduces desired consumption, but not by very much.
The real interest rate that is relevant to saving decisions is the expected after-tax real interest rate, which is the real return that savers expect to earn after paying a portion of the interest they receive in taxes.
4. With total output held constant, a temporary increase in government purchases reduces desired consump
tion. The reason is that higher government purchas es imply increases in present or future taxes, which makes consumers feel poorer. However, the decrease in desired consumption is smaller than the increase in government purchases, so that desired national saving, Y - cd - G, falls as a result of a temporary
increase in government purchases.
5. According to the Ricardian equivalence proposition, a current lump-sum tax cut should have no effect on desired consumption or desired national saving. The reason is that, if no change occurs in current or planned government purchases, a tax cut that increases current income must be offset by future
tax increases that lower expected future income. If consumers do not take into account expected future
tax changes, however, the Ricardian equivalence proposition will not hold and a tax cut is likely to
raise desired consump tion and lower desired national saving.
6. The desired capital stock is the level of capital that
maximizes expected profits. At the desired capital stock, the expected future marginal product of capital
1 42 Part 2 Long-Run Economic Performance
equals the user cost of capital. The user cost of capi tal is the expected real cost of using a unit of capital for a period of time; it is the sum of the depreciation cost (the loss in value because the capital wears out) and the interest cost (the interest rate times the price of the capital good).
7. Any change that reduces the user cost of capital or increases the expected future marginal product of cap ital increases the desired capital stock. A reduction in
the taxation of capital, as measured by the effective tax rate, also increases the desired capital stock.
8. Gross investment is spending on new capital goods.
Gross investment minus depreciation (worn-out or scrapped capital) equals net investment, or the change in the capital stock. Firms invest so as to achieve their desired level of capital stock; when the desired capital stock increases, firms invest more.
9. The goods market is in equilibrium when the aggre gate quantity of goods supplied equals the aggregate
K EY D I A G RAM 3
The saving
investment diagram
In an economy with no foreign trade, the goods market is in equilibrium
when desired national saving equals desired
investment. Equivalently, the goods market is in
equilibrium when the aggregate quantity of goods supplied equals
the aggregate quantity of goods demanded.
Diagram Elements
ft
.. . .. . , . . , .. . . .. .. . � . .. ft . . .. .. . . . .. .The real interest rate, r, is on the vertical axis; desired
national saving, sd, and desired investment, Id, are on the horizontal axis.
quantity of goods demanded, which (in a closed economy) is the sum of desired consumption, desired investment, and government purchases of goods and services. Equivalently, the goods market is in equi librium when desired national saving equals desired investment. For any given level of output, the goods market is brought into equilibrium by changes in the real interest rate.
10. The determination of goods market equilibrium, for any fixed supply of output, Y, is represented graphi cally by the saving-investment diagram. The saving curve slopes upward because empirical evidence suggests that a higher real interest rate raises desired saving. The investment curve slopes downward because a higher real interest rate raises the user cost of capital, which lowers firms' desired capital stocks and thus the amount of investment they do. Changes in variables that affect desired saving or investment shift the saving or investment curves and change the real interest rate that clears the goods market.
Saving curve,
S
Investment curve, I
Desired national saving,
S d,
and desired investment,Id
The saving curve, S, shows the level of desired national saving at each real interest rate. The saving curve slopes upward because a higher real interest rate increases the reward for saving and causes households to save more. (Empirically, this effect
outweighs the tendency of a higher real interest rate to lower saving by reducing the amount of saving necessary to reach any specified target.) Desired national saving is define d as 5d == Y - cd - G,
where is output, is desired consumption, and is government purchases.
The investment curve, I, shows the amount that firms want to invest in new capital goods at each real interest rate. The investment curve slopes downward because a higher real interest rate raises the user cost of capital and
thus lowers the amount of capital that firms want to use.
Analysis
Goods market equilibrium requires that desired national saving equal desired investment, or 5d == Id.
Goods market equilibrium occurs in the diagram at point E, where the saving curve and investment curve intersect. At E, desired national saving equals 51, desired investment equals 11, and 51 == 11 . The real
interest rate at E, r1, is the real interest rate that clears the goods market.
K EY T E RM S
Chapter 4 Consumption, Savi ng, and I nvestment 1 43
An alternative way to express the goods market equi librium condition is as follows: The quantity of goods
supplied, Y, equals the quantity of goods demanded by households, Cd, firms, Id, and the
;
overnment, G,or Y == cd + Id + G. As 5d == Y - C - G, this con
dition is equivalent to 5d == Id.
Factors That Shift the Curves
Any factor that raises desired national saving at a given real interest rate shifts the saving curve to the right; similarly, any factor that lowers desired national saving shifts the saving curve to the left. Factors that affect desired national saving are listed in Summary table 5, page 118. Similarly, factors that change desired investment for a given real interest rate shift the investment curve; see Summary table 6, page 130, for factors that affect desired investment. Shifts of either curve change the goods market equilibrium p oint and thus change national saving, investment, and the real interest rate.
consumption-smoothing
motive, p. 106
income effect of the real interest rate on saving, p. 112
substitution effect of the real
interest rate on saving, p. 111 desired capital stock, p. 121
effective tax rate, p. 126
expected after-tax real
marginal propensity to consume, p. 107
tax-adjusted user cost
of capital, p . 125
net investment, p. 128 user cost of capital, p. 122
interest rate, p. 113 gross investment, p. 128 Ricardian equivalence proposition, p. 117
K EY E Q U AT I O N S
(4.1)Desired national saving, 5d, is the level of national saving that occurs when consumption is at its desired level. Equation (4.1) is obtained by substituting desired con sumption, cd, for actual consumption, C, in the definition of national saving.
ra-t == (1 - t)i - '1Te (4.2)
The expected after-tax real interest rate, ra-t' is the after tax nominal interest rate, (1 - t)i, minus the expected rate of inflation, '1Te. The expected after-tax real interest rate is the real return earned by a saver when a portion, t, of interest income must be paid as taxes.
uc == rpK + dpK == (r + d)pK (4.3)
The user cost of capital, uc, is the sum of the interest cost, rpK, and the depreciation cost, dpK, where d is the depreciation rate and PK is the price of a new capital good.
MPKf == uc
1 - T
(r + d)pK
1 - T (4.4)
The desired capital stock, or the capital stock that maxi mizes the firm's expected profits, is the capital stock for which the expected future marginal product of capital, MPI<f, equals the tax-adjusted user cost of capital,
uc/(1 - T), where T is the tax rate on the firm's revenues (equivalently, the effective tax rate).
1 44 Part 2 Long-Run Economic Performance
The goods market equilibrium condition in a closed economy says that the goods market is in equilibrium when the aggregate quantity of goods supplied, Y, equals the aggre gate quantity of goods demanded, cd + Id + G.
sd == Id (4.8)
R E V I EW Q U E ST I O N S
ffii\1Weconlab
All review questions are available in
at www.myeconlab.com.
1. Given income, how are consumption and saving linked? What is the basic motivation for saving?
2. How are desired consumption and desired saving affect