Aims of the chapter

This chapter discusses the determinants of money demand and money supply. Money demand is assessed by first considering the different functions and definitions of money, and then looking at alternative microfounded theories of money demand, motivated by the public’s main reasons for holding money. Money supply is analysed by considering how the interactions between financial intermediaries (banks), the central bank and the private sector contribute to the determination of the money supply. The chapter also examines the conduct of monetary policy and assesses to what extent central banks can effectively control the money supply in an economy.

• describe the different definitions and functions of money, and evaluate how these have been affected by financial innovations over time
• describe microfounded theories of money demand based upon transaction and speculative motives for holding money
• discuss the links between the velocity of money and the demand for money
• discuss the mechanism of money creation and the determinants of the money supply
• explain why central banks do not have full control over the money supply.

This chapter is divided into three parts. We begin by revising the definitions of money and the role that money plays in an economy. Throughout the discussion we highlight how financial innovations, namely inventions of new means of payments, and technological progress, for instance the introduction of ATM machines, have contributed to change people’s spending habits, and thus money demand, over the last 50 years. Next, we focus on the determinants of money demand. In Chapter 2 of the guide the analysis of the money market underlying the derivation of the LM curve was based on the assumptions that money demand depends negatively on the interest rate (the opportunity cost of holding money) and positively on the level of income (which determines the transaction demand). In this chapter we provide a description of two key microfounded models of money demand: the Baumol-Tobin model of transaction demand and the Tobin model of speculative demand. Each model gives an alternative explanation for why money demand rises with higher income and falls with higher interest rates, and you need to be able to explain the motivations, provide a brief description, and critically assess each of them.

The third part of the chapter examines the determinants of money supply. In Chapter 2 of the subject guide we assumed that the money supply was under the direct control of the central bank. In this chapter we point out that the mechanism of money supply in the real world is much more complicated, since both commercial banks, through lending, and the private sector, by holding deposits, can also affect the money supply. We provide a simplified description of the role that the banking system and depositors have in the determination of money supply, and conclude by describing the different instruments that the central bank can employ to control the money supply.

Definition and functions of money

In Chapter 2 money was defined as a liquid asset, in the sense that it does not pay any interest and it can be used as a means of payment for
transactions, as opposed to bonds that cannot be used for transactions but pay an interest rate. In general, the less liquid an asset is the higher
the interest rate paid on it, but the more difficult is its use as a medium of exchange.

Monetary aggregates are classified according to their degree of liquidity. Currency refers to all coins and notes in circulation in an economy. M1 comprises currency and all those assets that, instantaneously and without restrictions, can be employed as a means of payments (i.e. interest- and non-interest-bearing current accounts, travel cheques, etc.). M2 includes all assets classified under M1 plus small-denomination time deposits and other short-term assets with fixed maturity. M3 and L include, in addition to M2, long-term deposits, assets, and government securities.

The classification and definition of monetary aggregates may vary across countries and, most importantly, has evolved over time as a result of financial innovations and the vast employment of computer technology to regulate economic transactions. Over the last 50 years, financial innovations and computer technology contributed to the introduction of new means of payment, and considerably increased the degree of liquidity of existing ones, in particular of bank accounts. In practice, this has made the distinction between liquid and non-liquid assets less and less clear cut. For instance, monetary assets such as current accounts once did not pay any interest, whereas nowadays they typically earn interest and are readily available for withdrawals through cash (ATM) machines. Another example concerns the classification of credit cards, which allow people to carry out
transactions without handling any currency. Effectively, credit cards are as liquid as currency, but could also be classified as part of M1 or M2 because they are, normally, issued against bank deposits.

Economists attribute to money four key functions. The function of money as a **medium of exchange** arises from the fact that money is generally accepted in exchange for any goods and services, hence it facilitates transactions since any goods and services can be exchanged for money at any time. The function of money as a **store of value** means that money keeps its value over time, as it is not subject to wear and tear or deterioration as most physical goods are. Money can also serve the function of being a **unit of account**, since it represents the unit at which all prices are quoted and firms’ books are kept. Finally, money can be used as a **standard or deferred payment**, in that it is accepted by the public to regulate both short- and long-term transactions, such as loans with short- and long-term maturities.

The demand for money

Under the Keynesian theory encountered in Chapter 2 of the subject guide, money demand was assumed to be positively related to income and inversely related to the nominal interest rate, which is the opportunity cost of holding money. In *The general theory of employment, interest and money*, Keynes highlights three basic motives for holding money:
• transaction motive
• precautionary motive and
• speculative motive.

People hold money for transaction motives since they need it to regulate payments. The precautionary motive is the demand for money to face unforeseen events. The speculative motive refers to the demand for money arising from a person’s desire to include it in their investment portfolio. In the next sections we will briefly discuss two microfounded models for money demand: the Baumol-Tobin model of transaction demand and the Tobin model of speculative demand for money.

Before describing these two models it is important to stress two points. The first refers to the link between the monetary aggregates and each motive for holding money. Baumol-Tobin’s model of transaction demand for money demand refers to M1, whereas Tobin’s models apply to the other broader monetary aggregates.

In addition, recall that the term ‘money demand’ in both models refers to the demand for real balances, correcting for changes in the purchasing power of nominal balances. Given the levels of output, interest rates and wealth, real money demand is unchanged when nominal money demand grows at the same rate as inflation, given the levels of real variables.

The Baumol–Tobin transactions demand model

The Baumol-Tobin model of transaction demand focuses on the function of money as a medium of exchange, and it is best employed to describe the demand for M1. The model assumes that each individual in the economy is endowed with an income Y t at the beginning of each year, and this income is deposited in a bank account. The individual has to spend the entire income over the course of the year and they have to decide the optimal
size of their cash balances over the same period of time. This is accomplished by minimising the total cost, TC t , of money holding,
M t / P t , given by:

TC t = i t (Y t/ 2 n) tc tn (11.1)

where n indicates the number of trips to the bank, i t is the interest rate, the term i t Y t /2n measures the foregone interest on the average amount of money held (given that Y t /n is the amount of money withdrawn each trip) and the term tc t × n measures the direct cost of making trips to the bank. The minimisation is carried out with respect to n, to determine the optimal number of trips to the bank to withdraw money. This optimal
money demand can be shown to depend positively on income and the cost of withdrawing money from the bank (transaction costs), and negatively
on the interest rate. Analytically, the optimal number of trips implies an average level of money holdings given by:

M t / P t = sqrt ( Y t tc t/ 2 i t) (11.2)

Therefore, the Baumol–Tobin model predicts that a larger diffusion of automatic cash machines and internet banking should reduce money demand for transactions, as it would reduce the cost of obtaining cash, tc t . Conversely, increases in banks’ fees and charges are likely to raise money
demand for transactions.

The Tobin speculative demand model

Tobin’s model of money demand for speculative motives focuses on the function of money as a store of value, and it is best employed to describe the demand for M2 and/or M3. The motivation behind the model is that money can be regarded as a safe asset, since its nominal value is known with certainty, as opposed to other risky assets, such as stocks and bonds, that may offer higher but more uncertain returns. For this reason, when deciding the composition of their asset portfolio, individuals may keep part of their wealth in the form of money as a sort of insurance against capital losses on assets for which the return is more uncertain.

For a simple description of the model, consider an investor who can choose between two assets: money and bonds. Money pays no interest and is a risk-free asset, in that its value does not change over time. In contrast, bonds yield a return but are risky assets, as their prices fluctuate over time. In period t, the investor forms a portfolio including a percentage θ 1 of real money and a percentage θ 2 of one-period bonds. To determine the shares
θ 1 and θ 2 , the investor evaluates the expected return from bonds. This can be described in terms of mean and standard deviation. The mean gives the average return that can be expected across bonds of similar maturity. The standard deviation measures the volatility of bond returns, and hence the risk associated with investment in them: the higher the volatility is, the higher the risk. Analytically, the expected return on the portfolio in period t is given by: E t [ R t + 1 ] = θ 2 absi ,

where abs i measures the average interest rate on bonds (remember that the return on the θ 1 , share of the portfolio held in money is zero). The volatility of the portfolio σ P depends entirely upon the volatility of the bond return, which is measured by its standard deviation σ b . The two measures are related by:
σ P = θ 2 σ b .

As a result, the portion of the portfolio held in the form of bonds can be expressed as:
θ 2 = σ P / σ b

This can be substituted into the expression for the portfolio return to obtain:

E t [ R t +1 ] = (i / σ b) σ P

The above highlights that there is a linear relationship between risk and return faced by the investor. Since i / σ b > 0 , a greater expected return can only be achieved by accepting higher risk in the form of a higher value for σ b . Consequently, this implies that money demand crucially depends upon risk preferences of investors. In general, the more risk-averse an individual is, the smaller is the share of their portfolio held in the form of bonds, and the higher their money demand. Beyond risk preferences, the main factors that affect money demand in the Tobin model are the nominal interest rate, higher values of which encourage bond holding and reduce money demand, and the volatility of bond returns, higher values of which increase money demand.

Empirical evidence on money demand

The two models of money demand described in the previous sections show that money demand should be related to income and the interest rate, thus providing a microeconomic justification for the money demand function employed throughout this course. The empirical evidence on money demand has established five key fundamental facts about money demand.

• First, the demand for nominal money is proportional to the price level, which confirms that money demand is indeed demand for real money
balances.
• Second, demand for real money balances is inversely related to changes in the interest rate, and directly related to changes in income. This finding is consistent with the assumptions of Keynesian theory and of the two microfounded models developed in this chapter.
• Third, money demand does not respond immediately to changes in income and the interest rate, but slowly adjusts over the course of
time. For this reason economists distinguish between short and long-run response (or elasticity) of money demand to changes in income
and in the interest rate.
• Fourth, the short-run response of money demand to changes in income and the interest rate is smaller than the long-run responses. The latter is estimated – for the USA – to be about five times greater than the former.
• Fifth, as a result of financial innovation that has made money deposited in savings accounts readily available for withdrawal, M1 demand has become more volatile over time than M2 demand. In particular, the long-run income elasticity of M2 is almost equal to unity, which implies that the ratio between M2 and real GDP should be constant over time.

Velocity and money demand

We complete the examination of money demand by revising the link between the velocity of money and money demand. The (income) velocity of money measures the number of times the stock of money is turned over during the year to finance annual GDP. Analytically, the velocity of money is defined as the ratio between nominal GDP and the nominal money stock, or, equivalently, as the ratio of real GDP to real money balances:

V t = P t Y t / M t = Y t/ (M t / P t) (11.3)

Since it depends upon income and the interest rate, the demand for real balances in Chapter 2 was described as:

M t / P t = L ( Y t , i t )

As suggested by the empirical evidence described in the previous section,
when demand for real balances refers to M2, an increase in income raises
money demand one-for-one. In this case, money demand can be written
as:

M t /P t = Y t L ( i t ) (11.5)

Equation (11.5) can be substituted into equation (11.3) to derive the
following relationship between velocity and the demand for real balances:

V t = P t Y t / M t = Y t / Y t L ( i t ) = 1 /L ( i t )

which shows that velocity is inversely related to money demand, since high money demand (relative to real GDP) implies low velocity. Therefore the concepts of velocity of money and money demand can be used almost interchangeably. Equation (11.6) also shows that velocity should be positively related to the interest rate. The empirical evidence shows that in the USA velocity – thus M2 demand – was relatively stable until the 1990s, but it has become increasingly volatile since then. For this reason, economists have since then become more sceptical about the effectiveness of monetary policy conducted through direct control of the money supply.

We are now in a position to re-interpret the **quantity theory of money**, which relates output, the price level and the nominal money stock to one
another, and can be analytically expressed by rearranging equation (11.4) as follows:
M t V t = P t Y t .

The quantity theory of money becomes the classical quantity theory of money under the assumptions that both velocity and real income are constant over time. The first assumption is consistent with the empirical evidence of a stable M2 demand, at least prior to the 1990s, whereas the second comes from assumption that output is at full employment (vertical supply curve). Under these assumptions, the price level is proportional to
the nominal money stock:

P t = VM t / Y

which implies that inflation is entirely determined by money growth [in the long run].

Money supply

In Chapter 2 of the subject guide, we assumed that the central bank supplies money to the economy by interacting directly with the public through open-market operations. This was a simplified version of the mechanism of money creation, which is discussed in more detail in this section.

First of all, it is important to understand the role of private or commercial banks, hereafter referred to just as banks, in an economy, and how they interact with the central bank. This is summarised in Table 11.1 which reports a stylised balance sheet of a commercial bank in a closed economy,
and a stylised balance sheet of the central bank.

Panel A shows that banks receive funds from individuals, households and firms, which deposit money in banks in the form of checkable deposits. Therefore the liabilities of banks are the money value of all checkable deposits. Depositors can use the money they hold in banks to regulate transactions by issuing cheques, by withdrawing money from ATM machines, through credit cards, etc. Banks can use deposits to make loans to individuals, households and firms, and to purchase non-monetary assets, such as bonds and stocks. Some of the funds received from depositors
are kept by banks as reserves, either in the form of cash, in an account at the central bank, or in accounts in other banks. Banks hold reserves to
cover depositors’ withdrawals and payments to other banks. In addition, banks are subject to reserve requirements established by the central bank,
which sets a minimum amount of money proportional to the checkable deposits, the reserve ratio, that has to be kept by each bank in the form
of reserves.

Although both loans and financial investment generate a return for banks in the form of interest, there is a fundamental difference between the two. As well as generating income for the bank, loans also contribute to expanding the supply of money. The process of lending provides borrowers with access to funds without diminishing the quantity of money held by depositors. This extra money is further deposited by borrowers (or those that they
transact with) in bank accounts, thus expanding the total amount of checkable deposits (M1) and the potential for other loans, hence allowing
further money expansion.

The presence of banks in an economy affects the composition of the liability section in the central bank’s balance sheet. Panel B in Table 11.1 shows that the monetary base issued by the central bank can be sub-divided into two categories. This money is partly held by the public in the form of currency, and partly by banks in the form of reserves.

A: Commercial banks 		B: Central bank 
Assets 		Liabilities 	Assets 		Liabilities
Loans 		Deposits 	Bonds 		Monetary base
Bonds 						– Reserves
Stocks 						– Currency
Reserves
Table 11.1: Commercial and central bank balance sheets.

With these definitions in mind, it is easy to design a basic model of the money supply.

The link between the monetary base, H, and money supply M s can be expressed analytically as:

M s = ((cd + 1) / (cd + rd)) H

where rd indicates the reserve-deposit ratio and cd is the ratio between the amount of currency held by the public and their holding of demand deposits. 2 Equation (11.7) shows the link between nominal money supply and the monetary base, which depends upon the reserve-deposit ratio and
the currency-deposit ratio.

Defining m = ( cd +1 ) / ( cd + rd) quation (11.7) can be written as: M s = mH where m indicates the so-called money multiplier. Note that since both
cd and rd are positive but rd is typically less than 1, the money multiplier is greater than 1,

m = ( ( cd + 1) / (cd + rd) ) > 1

This implies that an increase in the monetary base yields a more-than-proportional increase in the money supply. The money multiplier is generally larger the smaller are the reserve-deposit and the currency deposit ratios. The value of the currency-deposit ratio depends, among other things, upon the habits of the public and their preferences on how much cash to hold relative to deposits. These are affected by several factors, such as the interest rate on deposits, the cost of withdrawals, and how easy it is to access deposited money. In addition, the currency-deposit ratio changes over time, and is likely to be affected by seasonal factors (for instance, it tends to increase in specific periods of the year, such as Christmas and New Year).

Instruments of monetary control

The central bank has three instruments to control (indirectly) the money supply: open-market operations, the required reserve ratio and the discount rate.

Open-market operations are the most common instrument employed by central banks to change the monetary base and, consequently, the money supply. As already described in Chapter 2, with an expansionary open-market operation the central bank purchases bonds from the public, and the money paid for the bonds increases the monetary base, and hence the money supply. Conversely, a contractionary open-market operation occurs when the central bank sells bonds from the public, hence reducing the monetary base and money supply.

The reserve ratio is the minimum level of reserves that banks legally have to hold as a proportion of their checkable deposits, and it can be varied by the central bank to alter the money supply directly. As shown in equation (11.7), the reserve ratio affects the money multiplier. The central
bank can increase (reduce) the money supply by reducing (increasing) the reserve ratio.

The third instrument available to the central bank to affect the money supply is the **discount rate**. As described in the previous section, banks can hold reserves in the form of cash, or in an account at the central bank, or in accounts in other banks. If they are short of reserves, banks can borrow from either the central bank or from other banks. The discount rate is the interest rate charged by the central bank on funds lent to banks. The lower the discount rate is, the cheaper it is for banks to borrow from the central bank. This affects the cost of funds for banks, and hence their willingness to make loans to the private sector. An increase in the discount rate reduces banks’ willingness to lend, and hence tends to contract the money supply.

Blanchard, O., Johnson, D.R., (2013) Macroeconomics (sixth edition), Pearson

Chapter 4: Financial Markets

4-1 The Demand for Money

Money, which you can use for transactions, pays no interest. In the real world, there are two types of money: currency, coins and bills, and checkable deposits, the bank deposits on which you can write checks. The sum of currency and checkable deposits is called M1.

Bonds pay a positive interest rate, i, but they cannot be used for transactions. In the real world, there are many types of bonds and other financial assets, each associated with a specific interest rate.

Wealth, is the value of all your financial assets minus all your financial liabilities. In contrast to income or saving, which are flow variables, financial wealth is a stock variable. It is the value of wealth at a given moment in time.

Money market funds (the full name is money market mutual funds) pool together the funds of many people. The funds are then used to buy bonds—typically government bonds. Money market funds pay an interest rate close to but slightly below the interest rate on the bonds they hold.

An economy where the interest rate is equal or very close to zero is said to be in a liquidity trap.

Denote the amount of money people want to hold—their demand for money—by M^d (the superscript d stands for demand ). The demand for money in the economy as a whole is just the sum of all the individual demands for money by the people in the economy.

M^d = $Y L(-i)

The demand for money M d is equal to nominal income $Y times a function of the interest rate i , with the function denoted by L1i2. The minus sign under i in L1i2 captures the fact that the interest rate has a negative effect on money demand: An increase in the interest rate decreases the demand for money, as people put more of their wealth into bonds.

First, the demand for money increases in proportion to nominal income. If nominal income doubles, increasing from $Y to $2Y , then the demand for money also doubles, increasing from $Y L1i2 to $2Y L1i2.

Second, the demand for money depends negatively on the interest rate. This is captured by the function L1i2 and the negative sign underneath: An increase in the interest rate decreases the demand for money.

The relation between the demand for money and the interest rate for a given level of nominal income $Y is represented by the M d curve. The curve is downward sloping: The lower the interest rate (the lower i), the higher the amount of money people want to hold (the higher M). For a given interest rate, an increase in nominal income increases the demand for money.

4-2 Determining the Interest Rate: I

Suppose the central bank decides to supply an amount of money equal to M, so M^s = M

Equilibrium in financial markets requires that money supply be equal to money demand, that M s = M d . Then, using M s = M, and equation (4.1) for money demand, the equilibrium condition is

Money supply = Money demand
M = $Y L(i)

This equilibrium relation is called the LM relation. As for the IS relation, the name of the LM relation is more than 50 years old. The letter L stands for liquidity: Economists use liquidity as a measure of how easily an asset can be exchanged for money. Money is fully liquid; other assets less so.

The Determination of the Interest Rate

The interest rate must be such that the supply of money (which is independent of the interest rate) is equal to the demand for money (which does depend on the interest rate).

The Effects of an Increase in Nominal Income on the Interest Rate: An increase in nominal income leads to an increase in the interest rate.

An increase in the supply of money by the central bank leads to a decrease in the interest rate.

Let’s summarize what we have learned in the first two sections:

* The interest rate is determined by the equality of the supply of money and the demand for money.
* By changing the supply of money, the central bank can affect the interest rate.
* The central bank changes the supply of money through open market operations, which are purchases or sales of bonds for money.
* Open market operations in which the central bank increases the money supply by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate.
* Open market operations in which the central bank decreases the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.

4-3 Determining the Interest Rate: II

Banks are one type of financial intermediary. What makes banks special—and the reason we focus on banks here rather than on financial intermediaries in general—is that their liabilities are money.

The easiest way to think about how the interest rate in this economy is determined is
by thinking in terms of the supply and the demand for central bank money:
* The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks.
* The supply of central bank money is under the direct control of the central bank.
* The equilibrium interest rate is such that the demand and the supply for central bank money are equal.

The larger the amount of checkable deposits, the larger the amount of reserves the banks must hold, both for precautionary and for regulatory reasons.
If people want to hold D d in deposits, then, from equation (4.6), banks must hold thetaD^d in reserves.

The second component of the demand for central bank money—the demand for reserves by banks—is given by R^d = u1( - c )M^d

4-4 Two Alternative Ways of Looking at the Equilibrium*

Instead of thinking in terms of the supply and the demand for central bank money, we can think in terms of the supply and the demand for bank reserves

The supply of reserves is equal to the supply of central bank money H, minus the demand for currency by the public, CU d . The demand for reserves by banks is R d . So the equilibrium condition that the supply and the demand for bank reserves be equal is given by:

H - CU^d = R^d

There is yet another way of thinking about the equilibrium which is sometimes very useful. We can think about the equilibrium in terms of the equality of the overall supply and the overall demand for money (currency and checkable deposits).

Summary
* The demand for money depends positively on the level of transactions in the economy and negatively on the interest rate.
* The interest rate is determined by the equilibrium condition that the supply of money be equal to the demand for money.
* For a given supply of money, an increase in income leads to an increase in the demand for money and an increase in the interest rate. An increase in the supply of money for a given income leads to a decrease in the interest rate.
* The way the central bank changes the supply of money is through open market operations.
* Expansionary open market operations, in which the central bank increases the money supply by buying bonds, lead to an increase in the price of bonds and a decrease in the interest rate.
* Contractionary open market operations, in which the central bank decreases the money supply by selling bonds, lead to a decrease in the price of bonds and an increase in the interest rate.
* When money includes both currency and checkable de-posits, we can think of the interest rate as being determined by the condition that the supply of central bank money be equal to the demand for central bank money.
* The supply of central bank money is under the control of the central bank. The demand for central bank money depends on the overall demand for money, the proportion of money people keep as currency, and the ratio of reserves to checkable deposits chosen by banks.
* Another, but equivalent, way to think about the determination of the interest rate is in terms of the equality of the supply and demand for bank reserves. The market for bank reserves is called the federal funds market. The interest rate determined in that market is called the federal funds rate.
* Yet another way to think about the determination of the interest rate is in terms of the equality of the overall supply of and the overall demand for money. The overall supply of money is equal to central bank money times the money multiplier.

Chapter 16: Expectations, Consumption, and Investment

16-1 Consumption

The modern theory of consumption, on which this section is based, was developed independently in the 1950s by Milton Friedman of the University of Chicago, who called it the permanent income theory of consumption, and by Franco Modigliani of MIT, who called it the life cycle theory of consumption. Each chose his label carefully. Friedman’s “permanent income” emphasized that consumers look beyond current income. Modigliani’s “life
cycle” emphasized that consumers’ natural planning horizon is their entire lifetime.

Consumption is an increasing function of total wealth, and also an increasing function of current after-tax labor income. Total wealth is the sum of nonhuman wealth—financial wealth plus housing wealth—and human wealth—the present value of expected after-tax labor income.

Consumption is likely to respond less than one-for-one to fluctuations in current income.

Consumption may move even if current income does not change.

16-2 Investment

Depreciation. Based on their studies of depreciation of specific machines and buildings, they use numbers between 4% and 15% for machines, and between 2% and 4% for buildings and factories.

The Present Value of Expected Profits
The firm must then compute the present value of expected profits. The expected present value is equal to the discounted value of expected profit next
year, plus the discounted value of expected profit two years from now (taking into account the depreciation of the machine), and so on.

If the present value computation the firm has to make strikes you as quite similar to the present value computation we saw in Chapter 15 for the fundamental value of a stock, you are right. This relation was first explored by James Tobin, from Yale University, who argued that, for this reason, there should indeed be a tight relation between investment and the value of the stock market. His argument and the evidence are presented in the Focus box “Investment and the Stock Market.”

The sum of the real interest rate and the depreciation rate is called the user cost or the rental cost of capital. Investment depends on the ratio of profit to the user cost. The higher the profit, the higher the level of investment. The higher the user cost, the lower the level of investment.

16-3 The Volatility of Consumption and Investment

The theory of consumption we developed earlier implies that when faced with an increase in income consumers perceive as permanent, they respond with at most an equal increase in consumption.

Now consider the behavior of firms faced with an increase in sales they believe to be permanent. The present value of expected profits increases, leading to an increase in investment. In contrast to consumption, however, this does not imply that the increase in investment should be at most equal to the increase in sales. Rather, once a firm has decided that an increase in sales justifies the purchase of a new machine or the building of a new factory, it may want to proceed quickly, leading to a large but short-lived increase in investment spending. This increase in investment spending may exceed the increase in sales.

Consumption and investment usually move together: Recessions, for example, are typically associated with decreases in both investment and consumption.

Investment is much more volatile than consumption

Summary

* Consumption depends on both wealth and current income.
* Wealth is the sum of nonhuman wealth (financial wealth and housing wealth) and human wealth (the present value of expected after-tax labor income).
* The response of consumption to changes in income depends on whether consumers perceive these changes as transitory or permanent.
* Consumption is likely to respond less than one-for-one to movements in income. Consumption might move even if current income does not change.
* Investment depends on both current profit and the present value of expected future profits.
* Under the simplifying assumption that firms expect profits and interest rates to be the same in the future as they are today, we can think of investment as depending on the ratio of profit to the user cost of capital, where the user cost is the sum of the real interest rate and the depreciation rate.
* Movements in profit are closely related to movements in output. Hence, we can think of investment as depending indirectly on current and expected future output movements.
* Firms that anticipate a long output expansion, and thus a long sequence of high profits, will invest. Movements in output that are not expected to last will have a small effect on investment.
* Investment is much more volatile than consumption. But because investment accounts only for 15% of GDP and consumption accounts for 70%, movements in investment and consumption are of roughly equal importance in accounting for movements in aggregate output.