Suppose an individual experiences a $25,000 decrease in real income and the individual believes this decrease in income is permanent. Economic theory suggests that this individual's current consumption will:
A) decrease, remain unchanged, or increase, depending on the value of the real interest rate.
B) decrease by more than $25,000.
C) decrease at most by $25,000.
D) decrease or remain unchanged, depending on the value of the real interest rate.
E) decrease by less than $25,000.

Question

Quizplus · Accepted Answer

If the individual believes the decrease in income is permanent, they will adjust their consumption level to match their new lower income level. They will not borrow against future income to maintain current consumption levels, as they do not anticipate a return to their previous income level. Therefore, their consumption level will decrease by at most $25,000, the amount of the income decrease. The value of the real interest rate is not relevant in this scenario, as the individual is not borrowing or saving to maintain their consumption level.

Suppose an Individual Experiences a $25,000 Decrease in Real Income