Deck 14: Consumption and Saving

Question 1

Go to www.bea.gov and click on "Personal Income and Outlays," and then on "National Income and Product Accounts Tables." Click on "Begin using the data" and scroll down to "Section 5-Saving and Investment." Select Table 5.1 (Saving and Investment) and download data for gross saving as a percentage of gross national income over the last 40 years into EXCEL. Make a graph of the U.S. personal saving rate over the last 40 years. Is the personal saving rate pretty stable over time When did the personal saving rate start to fall in the United States

Answer 1

The permanent income can be calculated as the average of income over the past five years as shown below:
Consumption is given by C
0.9 YP
a.
If the income for last 10 years is same at $20,000 the permanent income can be calculated as shown below:
b.
If income for the next period raised to $30,000 in period
the permanent income can be calculated as shown below:
c.
Consumption is given by C
0.9 YP
Consumption for this year can be calculated as shown below:
Consumption for next year can be calculated as shown below:
d.
Marginal propensity to consume is the addition in consumption by an individual due to one unit increase in the income.
The short run MPC is calculated as shown below:
The long run MPC is calculated below:
C
0.9 YP
e.
From period
the income has increased to $30,000 for all periods. The permanent income will keep on increasing for the next five year.
The diagram showing the change in permanent income as average of last 5 year is changing for each period is given below:
Figure 1
X axis shows the time period whereas Y axis shows the permanent income. The curve shows the change in permanent income with time period.

Question 2

In the Barro-Ricardo view, does it make any difference whether the government pays for its expenditures by raising taxes or issuing debt
b. Why
c. What are the two main theoretical objections to the Barro-Ricardo view

Answer 2

There are various factors that affect consumption habits of an individual. Modern macroeconomic theory suggests various factors like saving, interest rates, etc. This brings up an issue of deficit and taxation as well.
a.
In the Barro-Ricardo view, it does not make a difference whether the government pays for its expenditures by raising taxes or issuing debt. The net result is the same with or without deficit.
b.
The reason is that government bonds merely postpone taxation. Their addition to the net wealth is highly questioned due to this reason. When the government does not borrow and raises taxes instead, an individual makes adjustment in his consumption pattern based on his disposable income after tax. On the other hand, if the government makes this expenditure by borrowing from individuals, it is merely a case of postponing taxes. Therefore, it does not matter whether the government raises taxes or issues debt.
c.
Barro-Ricardo proposition states that government bonds are not net wealth. There are two theoretical objections to this. First, since people have finite lifetimes, higher taxes will have to be paid by their descendants. This is not taken into consideration by them. Secondly, inability to borrow funds forces people to consume less than their permanent income. Therefore, a tax cut would ease this liquidity constraint, allowing them to consume more.

Question 3

Suppose that permanent income is calculated as the average of income over the past five years; that is,
YP = 1/5( Y + Y - 1 + Y - 2 + Y - 3 + Y - 4 ) (P1)
Suppose further that consumption is given by C =.9 YP.
a. If you have earned $20,000 per year for the past 10 years, what is your permanent income
b. Suppose that next year (period t + 1) you earn $30,000. What is your new YP
c. What is your consumption this year and next year
d. What is your short-run marginal propensity to consume Long-run MPC
e. Assuming you continue to earn $30,000 starting in period t + 1, graph the value of your permanent income in each period, using equation (P1).

Answer 3

The permanent income can be calculated as the average of income over the past five years as shown below:
Consumption is given by C
0.9 YP
a.
If the income for last 10 years is same at $20,000 the permanent income can be calculated as shown below:
b.
If income for the next period raised to $30,000 in period
the permanent income can be calculated as shown below:
c.
Consumption is given by C
0.9 YP
Consumption for this year can be calculated as shown below:
Consumption for next year can be calculated as shown below:
d.
Marginal propensity to consume is the addition in consumption by an individual due to one unit increase in the income.
The short run MPC is calculated as shown below:
The long run MPC is calculated below:
C
0.9 YP
e.
From period
the income has increased to $30,000 for all periods. The permanent income will keep on increasing for the next five year.
The diagram showing the change in permanent income as average of last 5 year is changing for each period is given below:
Figure 1
X axis shows the time period whereas Y axis shows the permanent income. The curve shows the change in permanent income with time period.

Question 4

Suppose you earn just as much as your neighbor but are in much better health and expect to live longer than she does. Would you consume more or less than she does Why Derive your answer using the equation from the text, C = ( WL / NL ) X YL.
b. According to the life-cycle hypothesis, what would be the effect of the social security system on your average propensity to consume out of (disposable) income Is the credibility of the social security system an issue here

Question 5

The graph below shows the lifetime earnings profile of a person who lives for four periods and earns incomes of $30, $60, and $90 in the first three periods of the life cycle. There are no earnings during retirement. Assume that the interest rate is 0.

a. Determine the level of consumption, compatible with the budget constraint, for someone who wants an even consumption profile throughout the life cycle. Indicate in which periods the person saves and dissaves and in what amounts.
b. Assume now that, contrary to part a , there is no possibility of borrowing. The credit markets are closed to the individual. Under this assumption, what is the flow of consumption the individual will pick over the life cycle In providing an answer, continue to assume that, if possible, an even flow of consumption is preferred. ( Note: You are assuming here that there are liquidity constraints.)
c. Assume next that the person described in part b receives an increase in wealth, or nonlabor income. The increase in wealth is equal to $13. How will that wealth be allocated over the life cycle with and without access to the credit market How would your answer differ if the increase in wealth were $23

Question 6

In terms of the permanent-income hypothesis, would you consume more of your Christmas bonus if ( a ) you knew there would be a bonus every year, or ( b ) this was the only year the bonus would be given

Question 7

Suppose that 70 percent of a country's population, as a consequence of liquidity constraints, behaves in accordance with the traditional model of consumption and thus consumes, every period, a given fraction of its disposable income. The other 30 percent of the population behaves in accordance with the LC-PIH.
a. If the MPC in the traditional model is.8 and disposable income changes by $10 million (you may assume that this change is due entirely to a change in transitory income), by how much will consumption change
b. What if 70 percent of the population behaves in accordance with the LC-PIH, and 30 percent behaves in accordance with the traditional model
c. What if 100 percent of the population behaves in accordance with the LC-PIH

Question 8

Explain why successful gamblers (and thieves) might be expected to live very well even in years when they don't do well at all.

Question 9

Suppose the real interest rate has increased from 2 to 4 percent.
a. What will happen to the opportunity cost of consuming a set of goods today, as opposed to tomorrow Explain how this will affect the fraction of income you choose to save.
b. Now suppose that you save only to finance your retirement and that your goal is to have $1 million tucked away by the time you're 70. Explain how your rate of saving will respond to the rise in the interest rate in this context.
c. Can you make a prediction regarding the net effect of this increase in r on the rate of saving Why, or why not

Question 10

What are the similarities between the life-cycle and the permanent-income hypotheses Do they differ in their approaches to explaining why the long-run MPC is greater than the short-run MPC

Question 11

Let's say that your goal is to raise the rate of saving in the United States by 3 percentage points. What are the various ways you could accomplish this Which of your solutions do you favor

Question 12

The United States, during the 1980s, found its rate of personal saving to be particularly low. It also, during that time, had a demographic blip-the baby-boomer generation, then in its late 20s to early 30s.
a. Does the life-cycle hypothesis suggest a reason that these two facts might be connected
b. What does this hypothesis suggest we should see as this generation ages

Question 13

Rank the following marginal propensities to consume:
a. Marginal propensity to consume out of permanent income.
b. Marginal propensity to consume out of transitory income.
c. Marginal propensity to consume out of permanent income when consumers are liquidity-constrained.
d. Marginal propensity to consume out of transitory income when consumers are liquidity-constrained.

Question 14

What is a random walk How is Hall's random-walk model of consumption related to the life-cycle and permanent-income hypotheses

Question 15

What are the problems of excess sensitivity and excess smoothness Does their existence disprove or invalidate the LC-PIH Explain.

Question 16

What assumption(s) regarding consumers' knowledge and behavior in the life-cycle- permanent-income hypothesis do we need to change in order for it to explain the presence of precautionary, or buffer-stock, saving Do these assumptions, in your opinion, bring the model closer to or further from the world as you know it

Question 17

The text implies that the ratio of consumption to accumulated saving declines over time until retirement.
a. Why What assumption about consumption behavior leads to this result
b. What happens to this ratio after retirement

Question 18

Explain why the interest rate might affect saving.
b. Has this relationship been confirmed empirically