Consumption and Investment

This paper presents an overview of current models of consumption and investment behavior. First, the stochastic implications of the permanent income model and empirical tests of these implications are discussed. Then the simple theoretical model is extended to include expenditure on consumer durables. In addition, the implications of liquidity constraints and the unpredictability of the rate of return on wealth are discussed. The overview of consumption behavior closes with a critical discussion of the Ricardia Equivalence Theorem. Investment behavior is analyzed using a dynamic optimization model of a firm facing costs of adjustment. This framework integrates the accelerator model, the neoclassical model and the q theory. The model is then used to analyze the interaction of corporate taxes, inflation and investment and also to analyze the effects of uncertainty on investment. The overview of investment concludes with a discussion of inventory investment.