1. Historically, the economy moves along the long‑run consumption schedule (Figure 15.4), for which consumption and saving are a relatively constant share of permanent income. Not everyone receives an income equal to his or her permanent income, however. Consequently, when we examine cross‑sectional data, those people with actual incomes greater than their permanent incomes will tend to have a saving rate somewhat higher than the average (and the reverse is true for those with incomes below permanent levels). Because people with high incomes are more likely to be in the group with actual incomes in excess of permanent incomes, the saving rate tends to be higher for that group.
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2. The PIH suggests that people base their spending patterns on long‑term, average incomes. Permanent changes in income cause changes in consumption based on this average response (long‑run marginal propensity to consume). Changes in actual income might be due to permanent or temporary changes. The latter will not cause changes in consumption unless the perception of permanent income changes. Thus, the change in consumption out of actual income (short‑run marginal propensity to consume) is much smaller because part of that income is considered transitory.
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3. Permanent income is not permanent. It is the consumer¡¦s expected average income. This can change if events cause the consumer¡¦s expectations to change. Passing the bar exam, being accepted into medical school, or receiving a promotion are events that would change an individual¡¦s estimate of his or her permanent income.
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4. The
legislation that created the tax rebate guaranteed these rebates 10 years into
the future. The strong suggestion, therefore, was that the tax rebate could be
considered permanent. However, in the absence of transitory income, an ¡§adaptive
expectations¡¨ model of permanent income would not immediately adjust its
valuation of permanent income to reflect a permanent decline in taxes
unless j =
1.
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5. The theory assumes that individuals use assets to increase consumption over their expected life span. If an individual planned no bequests, some of that person¡¦s assets would be consumed each year, until none remained at the end of the person¡¦s life. This behavior would allow consumption to be higher and saving to be lower for any given level of income.
6. According to the LCH workers save and retirees dissave. The overall household saving rate depends on the saving and consumption behavior of both groups. An increase in the proportion of the population that is retired raises total consumption relative to total income, thus causing the saving rate to decline. This effect on the saving rate could be offset by a number of means, including an increase in labor productivity that raises income per worker, an increase in the retirement age, or an increase in the number of working-age immigrants accepted into the country.
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7. (a) Permanent income will change for the workers let go because it is clear that they have a permanent job loss due to higher health care costs that Food-2-Go is being forced to pay. As for the workers retained, if they believe Food-2-Go when it says that they will work overtime on a regular basis, then they will view the increase in pay resulting from overtime as a permanent rise in income. On the other hand, if the workers take the layoffs as a signal that the company is experiencing difficulties, then that information may convince them that the overtime pay is transitory. It may take a period of a time before they are convinced that they will be working overtime on a regular basis.
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For workers let go, permanent income will decline initially by a larger amount if expectations are rational since it is assumed that they will earn less at whatever new jobs they get. This is because the higher pay that they earned at Food-2-Go will be used for some time in computing permanent income if expectations are adaptive, which would not be the case if expectations are rational. Once again, for workers retained by Food-2-go, whether permanent income changes by a larger amount initially if expectations are adaptive or rational depends on whether workers are convinced that they will be working overtime on a regular basis. If they are convinced of that fact, then they will include the overtime pay in the computation of permanent income and it will rise by that amount. If they believe that the overtime pay is transitory, then permanent income computed using adaptive expectations will initially be greater because the overtime pay will be included in the computation of permanent income.
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(b) Permanent income does not change since the overtime pay is due to an unusually snowy winter. The pay is clearly transitory in nature.
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(c) This is an increase in permanent income. While the person was expecting the promotion, she was not anticipating the amount of the pay increase. Therefore the pay increase represents a rise in permanent income. Permanent income will rise initially by a larger amount if expectations are rational as opposed to adaptive since her pay prior to the promotion will not be included in the computation of permanent income.
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8. Leaving bequests is compatible with the LCH. No one knows with certainty the length of one¡¦s ¡§life cycle.¡¨ Thus, if an individual uses a life horizon longer than the normal life expectancy, it is probable that when the individual dies, assets will remain.
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9. Yes, this observation is consistent with both hypotheses. For a younger family to smooth out consumption spending, the family might have to go into debt in the early years. If loans are unavailable, however, consumption might be constrained by the level of current income, with the result that an increase in current income, even if considered to be temporary, might be spent at a higher rate than the usual short‑run marginal propensity to consume would predict.
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10. The PIH and the
LCH hypothesize that consumption expenditures are relatively stable proportions
of expected (permanent or lifetime) income. They also predict that in a
recession, when transitory income falls, households cut back their ratio of
saving to personal income. For services and nondurables, enjoyment and spending
occur at roughly the same time. Durable goods, on the other hand, provide
enjoyment over an extended period of time. The purchase of durable goods is
often postponable. It is likely to respond to changes in transitory income to a
greater extent than expenditures on nondurable goods and services. These
observations help to explain the PIH and LCH prediction. Consumption of durable
goods is more volatile than consumption of nondurable goods, and both are more
volatile than consumption of services, which tend to grow smoothly. If consumer
durable expenditures were treated as if they were a form of saving, then the
relatively smooth consumption predicted by PIH and LCH is validated: people make
most of their adjustment to short-run changes in income by changing their ratio
of saving (including durables) to personal income.
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11. Because a
temporary tax change has a very small effect on permanent income, both the PIH
and LCH predict that such temporary changes would not have a very large effect
on consumption. For
a temporary tax cut, for example, the PIH and LCH predict that consumption would
remain relatively constant but the saving ratio would rise by approximately the
same amount that the tax‑income ratio fell. With a permanent tax cut, consumers
view their income as permanently higher and thus would consume at a higher rate.
Responses of consumers to the temporary tax surcharge of 1968 (when the saving
ratio fell suddenly) and to the temporary rebate in 1975 (when the saving ratio
rose dramatically) support this view. The permanent tax cuts carried out as part
of the Reagan fiscal plan were not matched by an upsurge in saving, suggesting
that consumers did, indeed, consider these cuts to be permanent. On the other
hand, a recent study by Shapiro and Slemrod found, surprisingly, that only 22
percent of those receiving the ¡§permanent¡¨ 2001 tax rebate reported that it
would lead them to increase spending.
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12. A rapid increase in economic growth can cause the saving rate to rise because the income of workers will be much higher than what retirees earned when they were working. Therefore the amount of saving done by current workers will exceed the amount of dissaving done by retirees, resulting in a higher saving rate.
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13. The larger capital gains from the stock market and housing in the United States, Canada, and Australia when compared to France and Italy allow consumers in the former set of countries to consume some of the increased value of their assets now and save less. On the other hand, households in France and Italy have not had as large a rise in asset values and therefore must rely more on saving out of current income in order to provide for consumption in the future.
14. A decline in consumption by retirees, when their income is lower, does not invalidate the LCH. If people believe that they will need to spend less when they retire, then they will take that into account when they make decisions concerning how much to consume out of current income at all points in their lifetime.
There are a number of reasons why retirees can cut their consumption. The first is that they can reduce housing expenditures by moving into either a smaller house or an apartment or to a location where housing is not as costly or because they no longer have to pay a mortgage on their residence. In addition, retirees no longer have the costs associated with working such as those for clothes, commuting, and perhaps more expensive lunches. Finally, retirees are able to spend more time searching for the lowest prices on those things that they do continue to buy.
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15. The late 1990s stock market boom accounts for the drop in the household saving rate according to the LCH. The stock market boom boosted the real value of household assets, inducing households to reduce their saving and, in effect, consume part of their stock market gains. This raised households¡¦ consumption expenditure relative to their current income and thus lowered their saving rate. However, a number of flaws in the NIPA saving measure cause economists to question its accuracy, and adjustment for these flaws suggest the household saving rate has increased along with the rising stock market. Including capital gains on stocks, bonds, and other assets, as well as purchases of consumer durable goods, in the definition of saving helps raise the measured household saving rate to average value of 37.7 percent of current household income over the period 1995¡V99, a sizable increase compared to the 1994 value.
16. No it is not true. In both 2000 and 2001, stock prices fell and did not continue to increase.
17. There are two reasons why the household saving rate remained low during 2002¡V04 despite the fact that during those years, the stock market remained well below the peak it reached in 2000. The first is that the Fed kept interest rates very low during those years, which stimulated booms in automobile sales and house refinancing. The refinancing of mortgages at lower interest rates allowed people to increase their expenditures on other goods and services.
Second, rapid appreciation of housing prices allowed people to maintain consumption despite a falling stock market. Professors Case, Quigley, and Shiller found that the effect on consumption of an increase in housing wealth is larger than that of an increase in stock market wealth.
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18. The answer is not clear-cut. On one hand, arguing that consumption is less responsive to sudden and temporary income changes, as the PIH and LCH both do, supports the views of policy-rules advocates regarding the stability of the private economy and the undesirability of active policy responses during such episodes. On the other hand, the procyclicality of consumer durable expenditures and the effects of changing asset prices on consumption envisioned by the LCH can destabilize the private economy, which activists can cite to support their views.
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