Question 1

Who came up with the life-cycle hypothesis?

Accepted Answer

Franco Modigliani (1950s)

Question 2

How is the life-cycle hypotheisis linked to Fishers model of intertemporal choice?

Accepted Answer

- Fisher’s model says that consumption depends on lifetime income, and people try to achieve a smooth consumption pattern (Euler equation). - The LCH says that income varies systematically over the phases of the consumer’s “life cycle,” and saving allows the consumer to achieve smooth consumption.

Question 3

What is the basic model of the life-cycle hypothesis?

Accepted Answer

The basic model: W = initial wealth Y = annual income until retirement (assumed constant) --\> varies systematically --\> income falls to zero at retirement so to smooth consumption you need to save to have money when you retire. R = number of years until retirement T = lifetime in years

Question 4

What are the assumptions of the life-cycle hypothesis?

Accepted Answer

- zero real interest rate (for simplicity) - consumption-smoothing is optimal

Question 5

How do you calculate your lifetime resources in life-cycle hypothesis model?

Accepted Answer

Lifetime resources = W + RY - To achieve smooth consumption, consumer divides her resources equally over time: C = (W + RY )/T , or C = aW+bY --\> where: - a = (1/T ) is the marginal propensity to consume out of wealth - b = (R/T ) is the marginal propensity to consume out of income

Question 6

How does the Life-Cycle Hypothesis solve the consumption?

Accepted Answer

The APC implied by the life-cycle consumption function is - C/Y = a(W/Y ) + b - so consumption is based on wealth and income not just income, and in the short term wealth and income do not vary protionately. - Across households, wealth does not vary as much as income, so high income households should have a lower APC than low income households. - Over time, aggregate wealth and income grow together, causing APC to remain stable.

Question 7

How is the Consumption fuction for the Life-cycle hypothesis different to Keynes model?

Accepted Answer

- different from Keynes model as he assumed autonomous consumption was fixed but our intercept here can change with wealth - Keynes focused on current income whereas the LCH focuses on income and wealth over lifetime.

Question 8

What are the short-run policy implications of the Life-cycle hypothesis model?

Accepted Answer

1. The Monetary Mechanism – wealth in the consumption function 2. Transitory (temporary) change in) Income Taxes --\> if you have a fixed income, and there is a change in income tax, the government need to consider how this will affect how much you consume and save between periods 0 to N ( retirement age)

Question 9

What are some criticism of Life-cycle model?

Accepted Answer

Criticism – saving behavior of the elderly: 1. Uncertainty --\> the model says that as soon as people hit retirement age they automatically switched to disaving, however in reality they did not consume savings at such a rapid rate due to uncertainty about the future due to medical bills or how long they would acutally live. 2. Bequest motive --\> the elderly didnt want to consume all their savings to pass onto their children - if they didnt have children they had a greater motive to save for uncertainty because if they ran out of money with family they have some to rely on but if not they would have to handle that themselves

Question 10

Who came up with the Permanent Income Hypothesis?

Accepted Answer

Due to Milton Friedman (1957)

Question 11

What is the basic Model of the Permanent Income Hypothesis?

Accepted Answer

•Y = YP + YT Where: Y = current income YP = permanent income average income, which people expect to persist into the future YT = transitory income temporary deviations from average income --\> win lottery all a bet --\> doesnt happen every year - Consumers use saving & borrowing to smooth consumption in response to transitory changes in income

Question 12

What is the Consumption Function Permanent Income Hypothesis?

Accepted Answer

•The PIH consumption function: C = aYP where a is the fraction of permanent income that people consume per year. - Friedman argued that income was the determinant of consumption like Keynes, but said he look at the wrong type of income - Friedman look at permant income (average income over the lifetime) not just current income

Question 13

How does the Permanent Income Hypothesis solve the consumption puzzle?

Accepted Answer

The PIH can solve the consumption puzzle: - The PIH implies APC = C/Y = aYP/Y - Friedman argued in the short term you are more likely to have changes in your transitory income - To the extent that high income households have on average a higher transitory income than low income households, the APC will be lower in high income households. - As high income households have the luxury to save their transitory income compared to those of low income households, so the APC is falling as we are saving more of that increase rather than consuming it - proportion of consumption is falling due tot the savings. - Over the long run, income variation is due mainly if not solely to variation in permanent income (pay rise or job change), which implies a stable APC.

Question 14

How can we use a two period model two demostrate the permanent and transitory change in income?

Accepted Answer

What can our simple two period model say about the temporary and permanent changes in income? Recall that Ct=f(Yt, Yt+1, rt) Show what will be the impact of a small change in each of the variable: ΔCt=(∂Ct/∂Yt) ΔYt+(∂C/∂Yt+1) ΔYt+1 +(∂C/∂rt) Δrt Assume ΔYt= ΔYt+1 and Δrt=0 --\> (no change in relative prices only want to look at wealth effect) then: A temporary change: ΔCt/ΔYt=(∂Ct/∂Yt) --\> increase is based on current income and not persistent so need to save A permanent change: ΔCt/ΔYt=(∂Ct/∂Yt) +(∂C/∂Yt+1) --\> this increase is persistent so dont need to save as much and consumption can be greatly effected if permant income changes Implication --\> consumption responds more to a permanent change in income

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L2 - Consumption Pt. 2 Flashcards

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