Question 1

Consumption is said to follow a random walk if:

Accepted Answer

If consumption follows a random walk, it means that changes in consumption are unpredictable and do not follow any discernible pattern or trend. This implies that consumers are not able to accurately forecast their future consumption levels or adjust their consumption behavior in response to changes in income or other economic variables, leading to erratic and volatile consumption patterns.

Question 2

If the permanent-income hypothesis is correct, and if consumers have rational expectations, then changes in consumption over time should be:

Accepted Answer

According to the permanent-income hypothesis with rational expectations, changes in consumption over time should be unpredictable because consumers smooth their consumption based on their expectations of their lifetime income, adjusting only when they receive new information that was not previously expected.

Question 3

Milton Friedman argued that, on average, consumption is:

Accepted Answer

Milton Friedman's Permanent Income Hypothesis suggests that consumption is proportional to an individual's permanent income, which is a long-term average income level, rather than being directly tied to temporary fluctuations in actual income.

Question 4

According to the permanent-income hypothesis, if consumers receive a permanent increase in their salary then they will:

Accepted Answer

According to the permanent-income hypothesis, consumers base their current consumption decisions on the expectation of their future (permanent) income rather than their current income. Therefore, if they receive a permanent increase in their salary, they are likely to increase their current consumption as well, since they expect their future income to be higher as well. This suggests that they will spend most of it in the current year rather than saving it.

Question 5

According to Friedman's permanent-income hypothesis, the marginal propensity to consume out of permanent income is ______ the marginal propensity to consume out of transitory income.

Accepted Answer

Friedman's permanent-income hypothesis suggests that individuals base their consumption decisions more on their long-term, or "permanent," income expectations rather than on short-term, or "transitory," income changes. Therefore, the marginal propensity to consume out of permanent income is greater than that out of transitory income, as individuals are more likely to save or not immediately spend unexpected, temporary income increases.

Question 6

If consumers obey the permanent-income hypothesis and have rational expectations, then ______ policy changes influence consumption.

Accepted Answer

According to the permanent-income hypothesis and rational expectations, consumers base their consumption decisions on their expected long-term income. Therefore, only unexpected changes in policy (such as unexpected tax cuts or increases in government spending) are likely to influence consumption in the short term, as they affect consumers' immediate disposable income. Expected policy changes, on the other hand, are already incorporated into consumers' long-term income expectations and are unlikely to have a significant impact on their current consumption decisions.

Question 7

Milton Friedman viewed current income as the sum of permanent income and:

Accepted Answer

Milton Friedman viewed current income as the sum of permanent income and transitory income. Transitory income is income that is not expected to continue in the long run, such as bonuses or temporary salary increases. Permanent income, on the other hand, is income that can be expected to continue over the long run, such as regular salary or investment income.

Question 8

According to the permanent income hypothesis, households will finance a temporary increase in taxes by: reducing _______ or increasing _____.

Accepted Answer

Households will finance a temporary increase in taxes by reducing saving or increasing borrowing, according to the permanent income hypothesis. This is because they aim to smooth consumption over time, rather than adjusting it dramatically in response to temporary changes in income or taxes.

Question 9

Permanent and transitory incomes differ in the way that permanent income is ______ than is transitory income.

Accepted Answer

Permanent income is more persistent than transitory income, meaning it is more stable and predictable over time. Transitory income, on the other hand, is more variable and can fluctuate rapidly due to factors such as changes in employment, bonuses, or other one-time sources of income.

Question 10

If consumers obey the permanent-income hypothesis and have rational expectations, then policy changes affect consumption when the policy changes:

Accepted Answer

According to the permanent-income hypothesis and rational expectations, consumers base their consumption decisions not only on their current income but also on their expected future income. Therefore, policy changes will only affect consumption if they change consumers' expectations about their future income. This means that the correct answer is C, which states that policy changes affect consumption when they change expectations. A and B are incorrect because policy proposals or changes going into effect alone do not necessarily change expectations. D is also incorrect because consumers may still react to policy changes even if they are not surprised by them.

Question 11

According to the permanent-income hypothesis, consumption depends primarily on ______ income.

Accepted Answer

The permanent-income hypothesis suggests that consumption is primarily determined by a person's permanent income rather than their current income. Permanent income is an individual's estimated long-term average income, taking into account fluctuations in income over time. This means that individuals will adjust their consumption patterns based on their expected long-term income rather than short-term changes in income. Therefore, choice C, permanent income, is the correct answer. Options A and D are incorrect because consumption is not influenced by short-term changes in income, also called transitory income. Option B is also incorrect because nominal income does not account for changes in inflation, so it does not provide an accurate estimate of long-term average income.

Question 12

According to the permanent-income hypothesis, if consumers receive a one-time income bonus, then they will:

Accepted Answer

The permanent-income hypothesis suggests that consumers base their consumption decisions on their long-term income expectations rather than on temporary changes in income. Therefore, if consumers receive a one-time income bonus, they are likely to save most of it, as it does not alter their long-term income expectations.

Question 13

Milton Friedman argued that, over long periods of time, the average propensity to consume is constant because, over these long periods of time:

Accepted Answer

Friedman argued that over long periods of time, the variation in income is dominated by the permanent component rather than the transitory component. Therefore, the average propensity to consume remains relatively constant because individuals base their consumption decisions on their long-term income outlook rather than short-term fluctuations.

Question 14

If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will increase when:

Accepted Answer

According to the permanent-income hypothesis, consumers base their current consumption on their expected long-term average income. An unexpected inheritance increases their perceived wealth and thus their long-term income, leading to an increase in current consumption. Choices A, B, and D involve anticipated changes, which should already be factored into their consumption decisions according to the rational expectations theory.

Question 15

Precautionary saving is saving for:

Accepted Answer

Precautionary saving is saving for unexpected or unpredictable expenses such as medical emergencies, job loss, or unexpected repairs. Retirement savings is typically planned and expected, and bequests to children are more focused on providing for future generations rather than immediate financial security. Repayment of debt previously incurred is also a planned expense rather than a precautionary one.

Question 16

According to Friedman's permanent-income hypothesis, if the marginal propensity to consume out of permanent income equals 0.9 and current income equals $55,000 (of which $5,000 is transitory income), then consumption should equal:

Accepted Answer

The answer of According to Friedman's permanent-income hypothesis, if the...

Question 17

Milton Friedman argued that, although household studies showed that high-income households generally have lower average propensities to consume, this phenomenon is due to the fact that these households have, on average:

Accepted Answer

The answer of Milton Friedman argued that, although household studies...

Question 18

Suppose that the government is considering two tax cuts, one temporary and one permanent. Each cut will give each taxpayer the same amount in the first year. The permanent-income hypothesis predicts that:

Accepted Answer

The permanent-income hypothesis suggests that individuals base their consumption on their long-term income expectations. Therefore, a permanent tax cut, which increases long-term disposable income, is likely to lead to more extra consumption in the first year compared to a temporary tax cut, which is seen as a short-term increase in income.

Question 19

Transitory income is:

Accepted Answer

Transitory income refers to random fluctuations in income, such as temporary bonuses, overtime pay, or unexpected windfalls. It is not a reliable part of an individual's average income and can vary greatly from year to year.

Question 20

Empirical studies of Franco Modigliani's life-cycle hypothesis show that:

Accepted Answer

Empirical studies have shown that the elderly do not use up all their savings in old age, which is contrary to what the simple version of the life-cycle theory predicts. This suggests that other factors, such as bequest motives or precautionary savings, may be at play.

Quiz 16: Understanding Consumer Behavior