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Solutions to the Problems in the TextbookConceptual Problems1.a. According to the life-cycle theory of consumption, people try to maintain fairly stable consumptionpaths over their lifetimes. Individuals save during their working years so they can keep up the same consumption stream after they retire. This implies that wealth increases steadily until retirement. But since consumption remains stable, we should expect the ratio of consumption to accumulated saving (wealth) to decrease over time up to retirement.1.b.The life-cycle hypothesis asserts that wealth is used up after retirement to finance consumption duringthe remaining years. This implies that the ratio of consumption to accumulated saving (wealth) increases after retirement, eventually approaching 1.2.a. Suppose that you and your neighbor both work the same number of years until retirement and youboth have the same annual income. If your neighbor is in bad health and does not expect to live as long as you, she will expect to have fewer retirement years in which to use accumulated wealth. Your neighbor's goal for retirement saving will not be as high as yours, and compared to you, she will havea higher level of consumption over her working years.Since planned annual consumption (C) is determined by the number of working years (WL), the number of years to live (NL), and income from labor (YL), we get the equation:C = [(WL)/(NL)](YL).WL and YL are the same for you and your neighbor, but NL is smaller for your neighbor. Therefore you will have a lower level of consumption (C).(Note: Students may come up with a variety of different answers. For one, your neighbor who is in bad health currently has much larger medical bills than you do. Therefore she may not be able to save as much for retirement, even if she might expect to live as long as you. On the other hand, she may not have large medical bills now, but expects them later, as she gets older. This may induce her to save more now. While such arguments are valid, instructors should point out that the answer should be related to the life-cycle theory and the equation used above.)2.b. If we assume for simplicity that the rate of return on Social Security is the same as the rate of returnon private saving, then the introduction of a Social Security system based on a trust fund should not have any effect on your level of consumption. Social Security may be considered a form of "forced saving," since you are forced to pay Social Security taxes during your working years and will, in return, receive benefits during your retirement years. However, most likely you would have voluntarily saved just as much as the government is now “forcing” you to save by levying the Social Security tax. Therefore your consumption behavior will not change. Still, the levying of a Social Security tax reduces disposable income during your working years, increasing the ratio of consumption to disposable income (the average propensity to consume).As we have just discussed, if private saving were simply replaced with government saving, national saving would not be affected. However, the Social Security system is actually not strictly financed through a trust fund, but largely on a pay-as-you-go basis. This means that most of the Social Security taxes are not "saved" but immediately used by the government to finance the benefits of current retirees. For this reason, many economists claim that the Social Security system has led to a decrease in the national savings rate and a decrease in the rate of capital accumulation. The magnitude of thisdecrease, however, has not been clearly established.The size of the Social Security trust fund was fairly insignificant until the system was amended in 1983. But now the trust fund is increasing and, in effect, largely contributed to the decreases in the federal budget deficits in the 1990s. However, because of our aging population, predictions are that the Social Security system will experience severe financial difficulties within the next 30 years unless it is reformed. If the credibility of the system becomes an issue, people may intensify their saving efforts, since they no longer feel they can rely on the public system to provide for them during retirement.3.a. If you expect to get a Christmas bonus every year from now on, you immediately treat it as part ofyour permanent income and spend accordingly, that is, ∆C = c(∆Y). In other words, your current consumption will change significantly.3.b. If you get a Christmas bonus for only this year but not for any future years, then you will consider itas transitory income. There is very little effect on your permanent income, so you will consume onlya small fraction of the bonus and save the rest. In other words, your current consumption will not besignificantly affected.4.Gamblers (or thieves) seldom have a very stable income. However, their consumption is determinedby their permanent income, that is, their expected average lifetime income. Since their permanent income is not significantly affected by any temporary change in income, their consumption pattern remains relatively stable, whether they do well or not in any given period.5.Both the life-cycle theory and the permanent-income theory try to explain why the short-run mpc issmaller than the long-run mpc. The life-cycle theory attributes the difference to the fact that people prefer a smooth consumption stream over their lifetime. Therefore the average expected lifetime income is the true determinant of current consumption. The permanent-income theory suggests that the difference is due to measurement errors. Measured income has two components—permanent and transitory income. But only permanent income is a true determinant of current consumption.6.a. One possible explanation for the low U.S. savings rate in the 1980s could be that the “baby boomers”were still in their dissaving phase. Since the households of the baby boom generation were still in their late twenties, they probably still had large expenses related to childcare and the purchase of houses. Therefore, they may not have been able to save for retirement.6.b.If the above explanation is correct, one can expect an increase in saving as these “baby boomers” age,become more financially solvent, and begin to prepare for retirement.7.The ranking from highest to lowest value should most likely be (a), (c), (d), and then (b). Clearly,(c) should be lower than (a), but it is not certain whether it should rank before or after (d); its exactranking depends largely on how severe the liquidity constraint is.8. A series follows a random walk when future changes cannot be predicted from past behavior. Inother words, it does not have a clear mean or long-run value and any major change results from a random shock. Hall asserted that changes in current consumption largely come from unanticipated changes in income. According to the life-cycle theory and permanent-income theory, people try to smoothen out their consumption stream in such a way that its expected value is always the same in each period. Therefore, we can express future consumption as the expected value plus some errorterm, that is, some random value that is unpredictable. This error term is a shock to future income that is spread over the remaining lifetime. Hall supported the permanent-income hypothesis by showing that lagged consumption is the most significant determinant of future consumption.9. The problem of excess sensitivity means that consumption responds more strongly to predictablechanges in current income than the life-cycle theory and permanent-income theories predict. The problem of excess smoothness means that consumption does not respond as strongly to unpredictable changes in current income as these theories predict. However, the existence of these problems does not invalidate the theories. It simply means that the theories can explain consumption behavior only to a certain degree.10.Precautionary (or buffer-stock) saving can be explained by uncertainty. It could be uncertainty inregard to one’s life expectancy or one’s time of retirement (affecting the accumulated saving needed to finance retirement), or uncertainty about future spending needs (which may be caused by a change in family composition or health). Clearly, if we account for such uncertainties, we bring the model closer to reality. For example, many elderly continue to save after retirement in anticipation of later high medical costs.11.a.It is unclear whether an increase in the interest rate leads to an increase or a decrease in saving. Onthe one hand, as the interest rate increases, the return on saving increases and people may therefore increase their savings effort (due to the substitution effect). On the other hand, a higher return on saving implies that a given future savings goal can now be reached with a smaller savings effort in each year (due to the income effect).11.b.The income effect and the substitution effect generally tend to go in different directions; the overalloutcome depends on the relative magnitude of these two effects. Until now, empirical evidence has not established a significant sensitivity of saving to changes in the interest rate. This would imply that the income and substitution effects have about the same magnitude.12.a. According to the Barro-Ricardo proposition, it does not matter whether an increase in governmentspending is financed by taxation or by issuing debt.12.b. The Barro-Ricardo proposition states that people realize that when the government finances its debtby issuing bonds, it simply postpones taxation. In other words, people know that the government will have to raise taxes in the future to pay back what they have borrowed now, and people want to be prepared to pay future taxes. Therefore, expansionary fiscal policy that results in an increase in the budget deficit will not stimulate the economy since it will lead to an increase in saving rather than consumption.12.c.There are two main objections to the Barro-Ricardo hypothesis. One is based on liquidity constraints,that is, people cannot consume out of their permanent income, since they can’t borrow. Therefore, a tax cut eases their liquidity constraints and they consume more rather than save the tax cut. The other argument is that those people who benefit from a tax cut or an increase in government spending are not the same as those who will have to pay the higher taxes to pay off the debt. This argument assumes that people are not concerned about the welfare of their descendants.Technical Problems1.a. If income remains constant over time, permanent income equals current income. Your permanentincome this year is YP0 = (1/5)(5*20,000) = 20,000.1.b.Your permanent income next year is YP1 = (1/5)(30,000 + 4*20,000) = 22,000.1.c.Since C = 0.9YP, your consumption this year is C0 = 0.9*20,000 = 18,000.Your consumption next year is C1 = 0.9*22,000 = 19,800.1.d.In the short run, the mpc = (0.9)(1/5) = 0.18; but in the long run, the mpc = 0.9.1.e. In 1.a. and 1.b., we have already calculated this and next year's permanent income. For each of thecoming years you add $30,000 and subtract $20,000. Therefore your permanent income (which is your average over a five year period) will increase by $2,000 each year until it reaches $30,000 after5 years.YP o=(1/5)(5*20,000) =20,000YP1 = (1/5)(1*30,000 + 4*20,000) = 22,000YP2 = (1/5)(2*30,000 + 3*20,000) = 24,000YP3 = (1/5)(3*30,000 + 2*20,000) = 26,000YP4 = (1/5)(4*30,000 + 1*20,000) = 28,000YP5=(1/5)(5*30,000) =30,0002.a.The person lives for NL = 4 periods and earns a lifetime income ofYL = 30 + 60 + 90 + 0 = 180.Therefore consumption in each period will beC i = (1/4)180 = 45, i = 1, 2, 3, 4.This implies that saving in each period is:S1 = 30 - 45 = - 15; S2 = 60 - 45 = + 15; S3 = 90 - 45 = + 45; S4 = 0 - 45 = - 45. 2.b. If there are liquidity constraints and the person cannot borrow in the first period, then she willconsume all of her income, that is, Y1 = C1 = 30.For the remaining three periods the person wants a stable consumption stream. Thus she will consume C(i) = (1/3)(60 + 90 + 0) = 50 in each of the remaining three periods i = 2, 3, 4.2.c. An increase in wealth of only $13 is not enough to offset the difference in consumption patternsbetween period 1 and the other periods. Therefore all of the increase in wealth will be consumed in period 1, such that C1 = 43. In the remaining three periods, consumption will be the same as in 2.b.An increase in wealth of $23 will be enough to offset the difference in consumption patterns.Lifetime consumption in each period will now be C i = (1/4)(180 + 23) = 50.75. This means that 20.75 (or almost all of the additional wealth) will be used up in the first period; the remaining 2.25 will be distributed over the next three years.3.a.According to the life-cycle theory and permanent-income hypothesis (LC-PIH), the change inconsumption equals the surprise element, that is, ∆C LC-PIH = є. According to the traditional theory, the change in consumption equals ∆C tr = c(∆YD). Therefore if a fraction λ of the population behaves according to the traditional theory and the other fraction behaves according to LC-PIH, the total change in consumption is∆C = λ(∆C tr) + (1 - λ)(∆C LC-PIH) = λc(∆YD) + (1 - λ)є = (0.7)(0.8)10 + (0.3) = 5.6 + (0.3)є.3.b.∆C = (0.3)(0.8)10 + (0.7)ε = 2.4 + (0.7)є3.c.∆C = (0)(0.8)10 + 1є = є4.a. If the real interest rate increases, the opportunity cost of consuming should increase.Therefore, the average propensity to save, that is, the fraction of total income that is saved, should increase.4.b. If you only save for retirement and your savings goal is fixed, then you actually will saveless. With a higher interest rate it will take less saving each year to achieve your goal.4.c. The first case (4.a.) describes the substitution effect, whereas the second case (4.b.)describes the income effect. Unless the magnitude of each of these effects is known, we cannot predict the overall effect of the interest rate increase on saving.5. One way to increase national saving would be to either privatize or eliminate the SocialSecurity system, so people would have to save for retirement on their own. (Eliminating Social Security is not a very popular measure, although the privatization of Social Security is often discussed.) This would do away with the negative effect on saving that comes from the pay-as-you-go nature of financing Social Security. Another way might be to make it more difficult to borrow. The U.S. tax system encourages people (and firms) to borrow rather than save. Finally, since national saving is equal to private saving plus government saving, lowering the budget deficit would increase national savings. However, to accomplish this, the government would have to either cut spending or raise taxes.。
《经济学原理——宏观经济学》PRINCIPLES OF ECONOMICS: MACROECONOMICSAssignment 2 (Week 3) Consumption, Saving and Investment1. (a) The relationship between consumption expenditure and disposable income is called the____________. The relationship between saving and disposable income is called the ____________. Negative saving is called ____________. (b) The ratio of consumption expenditure to disposable income is called the____________ to consume, and the ratio of saving to disposable income is called the ____________ to save. (c) The fraction of the last yuan of disposable income that is spent on consumption is called the ____________. (d) As disposable income increases, consumption expenditure ___________ and saving ___________.2. (a) The observed interest rate minus the expected ____________ rate gives the realinterest rate. As the real interest rate rises, planned investment expenditure ___________. The curve showing the relationship between the real interest rate and the level of planned investment (holding other things constant) is called the ____________ curve. (b) The higher the expected profitability of new capital equipment, the ____________ is the amount of investment. The more depreciation that takes place, the ____________ is the volume of investment that is needed to replace that worn-out capital. Thus a rise in the expected profitability or an increase in depreciation will cause the investment demand curve to shift to the ____________. (c) The _____accelerator_______ principle states that the investment demand curve will shift in response to changes in the level of real GDP.3. Consider an economy of 1 million identical households, each of which has aconsumption function as illustrated in the graph of the above question. Suppose further that net taxes are one third of real GDP.(a) What is the marginal propensity to consume out of disposable income?(b) What is the marginal propensity to consume out of real GDP?(b) Draw the aggregate consumption function for this economy.4. The following graph illustrates the consumption function for a household. Thedisposable income is at the moment Ұ20,000.(a) Compute the average propensities to consume (APC) and to save (APS).(b) Compute the marginal propensities to consume (MPC) and to save (MPS).(c) Compute the level of saving.(d) Given the form of the consumption functions as: C = a + bY d , where C is the consumption expenditure, and Y d the disposable income. What are the meanings of ‘a’ and ‘b’?(e) Express the saving function in terms of a, b, and Y d , and find the MPS.(f) Draw a graph under the one given in the question to illustrate the saving function.45o lineConsumption f unction1218Yd(?,000)C (?,000)Yd(?,000)S (?,000)5. Use the data for an economy given below to response to the following:Consumption expenditure (C) Ұ600 bn Taxes (TX) 400 bn Transfer Payments (TR)250 bn Exports (EX) 240 bn Imports (IM)220 bn Government spending on goods and services (G) 200 bn Gross Investment (I) 150 bn Depreciation (Depr)60 bn(a) Compute GNP. Which approach you are using? (b) Compute net investment. (c) Compute net exports.(d) Compute disposable income (Y d ). (e) Compute saving (S).(f) Compute total leakages from and total injections into the circular flow of income. Arethey equal?。
Chapter 13Consumption and Saving Multiple Choice Questions1. Consumption is an important element of aggregate demand because ita. Is the most volatile componentB. Accounts for roughly 70 percent of aggregate demandc. Is very interest sensitived. Is greatly affected by stock market activitye. All of the aboveDifficulty: Easy2. When the aggregate consumption function is defined as C = C o + cYD, thena. The mpc increases with higher levels of disposable incomeB. The mpc is constant at all levels of disposable incomec. The apc is constant at all levels of disposable incomed. The apc increases with higher levels of disposable incomee. The expenditure multiplier is less than oneDifficulty: Easy3. According to the simplified life-cycle theory of consumption, a retired person with zero income from labor woulda. Only consume the interest on accumulated wealthB. Consume a fraction of accumulated wealth based upon her/his life expectancyc. Have to decrease consumption sharply in order not to run out of funds too soond. Expect to be financially supported by her/his childrene. Consume more than during her/his working years since she/he does not expect to live much longerDifficulty: Medium4. The long-run marginal propensity to consume (mpc) isA. Larger than the short-run mpcb. Slightly smaller than the short-run mpcc. About half the size of the short-run mpcd. Identical to the short-run mpce. Always equal to 1Difficulty: Easy5. The debate about different consumption theories can be viewed as a debate over whethera. The consumption of durable or non-durable goods should be consideredb. Random events that can change consumption behavior really do occurc. Liquidity constraints do ever existD. The marginal propensity to consume is large or smalle. The average propensity to consume is less or greater than 1Difficulty: Easy6. The life-cycle theory of consumption implies thata. The mpc out of wealth is very smallb. The mpc out of permanent income is larger than the mpc out of transitory incomec. A large change in stock values can affect the economy, but the effect is fairly smalld. An individual's mpc out of permanent income changes with ageE. All of the aboveDifficulty: Medium7. According to the life-cycle theory of consumption, an individual'sa. Mpc out of wealth is fairly largeb. Mpc out of labor income increases with increasing age, until it becomes zero at retirement ageC. Mpc out of transitory income is fairly smalld. Level of consumption will decrease if his/her retirement age is increasede. None of the aboveDifficulty: Medium8. The life-cycle theory of consumption can be summarized as follows:a. Retired people need less so they can save more than working peopleb. People want instant gratification and seldom worry about the futurec. People always tend to consume almost all of their current incomeD. People plan their consumption and saving patterns to optimize the lifetime benefit from their disposable incomee. People adjust their current consumption constantly to keep a stable saving pattern over their lifetimeDifficulty: Medium9. According to the life-cycle theory of consumption, what should have occurred after the stock market crash of 1987?A. A decrease in current consumptionb. No change in current consumption since only nominal wealth was lostc. No change in aggregate consumption since most people do not invest in the stock marketd. An increase in consumption since people were afraid to savee. Both B and CDifficulty: Medium10. In 1968, President Johnson and Congress implemented a temporary surcharge on personal and corporate income taxes. What was the effect of this?a. Economic activity declined sharply and the economy entered a recessionb. Consumption and investment spending declined significantlyC. Households decreased their savings and aggregate demand was hardly affected at alld. Consumption and saving declined, while investment was not affectede. Both A and BDifficulty: Medium11. If we compare the life-cycle theory of consumption with the permanent-income theory we can conclude that they bothA. Pay careful attention to microeconomic foundationsb. Agree that temporary tax cuts can be used to stimulate the economyc. Have similar theoretical bases but disagree widely in their policy implicationsd. Explain why large changes in current income cause large changes in current consumptione. None of the aboveDifficulty: Medium12. Which of the following theories of consumption behavior was introduced by Milton Friedman?a. The absolute-income hypothesisb. The relative-income hypothesisC. The permanent-income hypothesisd. The life-cycle hypothesise. The random-walk hypothesisDifficulty: Easy13. The life-cycle theory of consumption was first advanced bya. James Duesenberryb. Milton Friedmanc. Robert Halld. John Maynard KeynesE. Franco ModiglianiDifficulty: Easy14. The permanent-income theory of consumption implies thatA. The short-run multiplier is smaller than the long-run multiplierb. The short-run multiplier is larger than the long-run multiplierc. The short-run multiplier is identical to the long-run multiplierd. The long-run multiplier is equal to 1e. The short-run multiplier is less than 1Difficulty: Easy15. According to the permanent-income theorya. Increases in current income lead to proportionate increases in consumption and savingb. A rise in income affects consumption only after a delay of several yearsc. A person's consumption in any given year will be strongly affected by interest rate changesd. A person's consumption in any year will always be closely tied to his/her highest previous level of consumptionE. None of the aboveDifficulty: Medium16. If you are age 20, have no accumulated wealth, and have an expected average annual income of $36,000, how much should you consume each year if you want to retire at age 65 and expect to live until age 80? You desire to leave no estate and to consume an equal amount in each of the next 60 years.a. $36,000b. $31,000C. $27,000d. $22,000e. $20,000Difficulty: Medium17. Assume a worker at age 25 with annual earnings of $45,000 who wants to retire at age 65 and expects to live until age 75. How much would the worker consume annually?a. $40,000B. $36,000c. $32,000d. $30,000e. $28,000Difficulty: Medium18. The permanent-income theory of consumption asserts that people prefer a stable level of consumption throughout their lives anda. Will forego temporary or transitory opportunities to obtain higher income and consumption B. Calculate their level of consumption from the information they have regarding their average expected lifetime incomec. Will only change their consumption behavior significantly if there is a transitory change in their incomed. This implies that the short-run mpc is greater than the long-run mpce. Therefore always save the same fraction of their current incomeDifficulty: Easy19. According to the permanent-income theory of consumption, a person whose income fluctuates widely from year to year will havea. A higher apc in high-income years than in low-income yearsB. A lower apc in high-income years than in low-income yearsc. A consistently high apc year after yeard. A consistently low apc year after yeare. An apc that is equal to 1Difficulty: Medium20. According to the permanent-income theory, if individuals A and B have the same average annual income but A's income fluctuates greatly from year to year while B receives an almost even flow of income each year, thena. A will spend less than B out of permanent incomeb. B will spend less than A out of permanent incomeC. A will weigh current income less heavily in making consumption decisions than Bd. B will weigh current income less heavily in making consumption decisions than Ae. A's consumption will always be less than B'sDifficulty: Easy21. According to the permanent-income theory, which of the following would have the greatest impact on the current consumption of a 45 year-old tenured college professor?A. A promotion to full professor combined with a $5,000 raiseb. A $5,100 advance payment for a book that will take two years to writec. Winning $5,200 in the Reader's Digest Sweepstakesd. A loss of a stamp collection worth $5,400e. An inheritance of $5,500 from a distant uncleDifficulty: Easy22. If a worker gets a large one-time Christmas bonus, most likely the following will occur:a. An immediate substantial increase in family consumptionb. Permanent family income will increase substantiallyc. Transitory family income will not be affectedD. Family saving will increase that yeare. All of the aboveDifficulty: Easy23. What does the permanent-income theory of consumption predict you would most likely do with $25,000 that you just won on a TV game show?a. Travel throughout Europe and eat in five-star restaurantsb. Invite all your friends to a big bashC. Put the money in the bank to finance your next year in colleged. Take a trip to Las Vegas to try and double your winningse. None of the aboveDifficulty: Easy24. Assume you unexpectedly inherit $20,000. Which of the following fits the life-cycle or permanent-income theory of consumption?a. You buy yourself some blue chip stocksb. You pay back part of your student loanc. You spend $600 on a new Playstation and use the rest to buy government bondsd. You deposit $1,000 in your checking account and $19,000 in your savings accountE. All of the aboveDifficulty: Medium25. According to the permanent-income theory of consumptiona. Permanent income is always lower than transitory incomeb. The mpc out permanent income is close to zeroc. The mpc out of transitory income is close to 1d. All of the aboveE. None of the aboveDifficulty: Medium26. A temporary tax change will significantly affect current consumptiona. But only if it does not come as a surpriseB. If liquidity constraints existc. But only for the elderlyd. As long as it does not lead to a budget deficite. None of the aboveDifficulty: Medium27. Assume you define your permanent income as the average of your income over the most recent five years, and you always consume 90% of your permanent income. What is your current consumption if your income was $30,000 in the first of these five years and each year from then on you got a raise of $2,000?a. $36,000b. $34,200C. $30,600d. $28,800e. $27,000Difficulty: Difficult28. The random-walk theory of consumption predicts thatA. The slope of a line relating C(t+1) to C(t) is equal to 1b. The slope of a line relating C(t+1) to C(t) is equal to 0c. The slope of a line relating C(t+1) to C(t) is close to 0d. The slope of a line relating C(t) to Y(t) is close to 1e. None of the aboveDifficulty: Medium29. Robert E. Hall's theory of consumption behavior is calleda. The absolute-income hypothesisb. The permanent-income theoryC. The random-walk theoryd. The buffer-stock theorye. The life-cycle theoryDifficulty: Easy30. Hall's random walk-theory of consumption states that consumption tomorrow should equala. Income tomorrow minus income today plus some random errorb. Income today minus consumption today plus some random errorC. Consumption today plus some random errord. Permanent income plus some random errore. Income tomorrow plus some random errorDifficulty: Easy31. The random-walk theory of consumption asserts that changes in consumption arise from unexpected changes in income. This approacha. Clearly contradicts Modigliani's theoryb. Clearly contradicts Friedman's theoryc. Contradicts Modigliani's theory but supports Friedman's theoryd. Supports Modigliani's theory but contradicts Friedman's theoryE. Supports Modigliani's and Friedman's theoriesDifficulty: Medium32. Actual consumption behavior exhibits both "excess smoothness" and "excess sensitivity," which means thata. Consumption responds too strongly to surprise changes in incomeb. Consumption responds too little to predictable changes in incomec. Consumption always follows a random walkd. Consumption always adjusts with long lagsE. None of the aboveDifficulty: Medium33. The fact that consumption exhibits "excess sensitivity" implies that consumptionA. Responds too strongly to predictable changes in incomeb. Responds too little to predictable changes in incomec. Responds too little to surprise changes in incomed. Is never affected by liquidity constraintse. Never behaves as Keynes predictedDifficulty: Medium34. The sensitivity of current consumption to changes in current income arises fromA. Liquidity constraintsb. The close relation between current consumption and permanent incomec. Income changes that tend to be mostly random and unpredictabled. The close relation between current and lagged consumptione. None of the aboveDifficulty: Medium35. The sensitivity of current consumption to changes in current income can be explained byA. Myopiab. The absence of liquidity constraintsc. The fact that consumers have the opportunity to borrowd. The fact that consumers always realize when a permanent change in income has occurrede. None of the aboveDifficulty: Medium36. Buffer-stock savingA. Is consistent with the life-cycle hypothesis if uncertainty about future needs is includedb. Disproves the life-cycle hypothesisc. Is the result of a permanent increase in income that is not immediately consumedd. Explains the wealth effecte. None of the aboveDifficulty: Medium37. If uncertainty about future income and future needs is incorporated into the life-cycle theory of consumption, thena. Buffer-stock saving can no longer be explainedb. The fact that consumption is interest sensitive can be explainedC. The fact that people rarely use up their lifetime saving can be explainedd. The fact that saving is interest sensitive can be explainede. It is significantly different from the permanent-income theoryDifficulty: Medium38. Empirical studies of aggregate consumption have shown thata. 100% of the variation in consumption can be explained by changes in current incomeB. Wealth effects generally account for only a small amount of consumer expendituresc. Wealth effects generally are very large, which explains the large variations in consumption from year to yeard. Changes in wealth have a bigger impact on consumption than changes in incomee. The marginal propensity to consume out of wealth is close to oneDifficulty: Medium39. The theory of consumption of durable goodsA. Is basically a theory of investment applied to householdsb. States those durable goods purchases are very insensitive to interest rate changesc. Can be explained very well by the life-cycle theory, since people spread their durable goods purchases equally over their lifetimesd. Suggests that expenditures on durable goods do not increase utility as much as expenditures on other consumption goodse. None of the aboveDifficulty: Medium40. Liquidity constraints explaina. Why consumers may spend less than the permanent-income theory predicts as their current income fallsb. Why consumption may increase more than the life-cycle hypothesis predicts when income recovers after a recessionc. Why consumers may sometimes behave in a manner predicted by the simple Keynesian consumption functionD. All of the abovee. None of the aboveDifficulty: Medium41. Assume the government announces an income tax surcharge of 10% for next year only and the Fed announces that it will keep interest rates constant. What effect do you think this will have on the economy?a. Households will immediately curtail their spending and aggregate demand will decline significantly, causing a recessionb. Households will reduce their spending significantly starting next yearC. Households will not significantly alter their spending behavior this or next year and the effect on the economy will be minimald. Households will spend a lot more this year, causing a temporary boome. Households will save a lot more this year so they won't have to reduce their spending next yearDifficulty: Medium42. If the interest rate increases,a. Consumption of non-durable goods will decrease substantiallyb. Saving will increase substantiallyc. Consumption of durable goods will increase substantiallyd. Both B and CE. None of the aboveDifficulty: Medium43. There is empirical evidence for the fact thata. An increase in interest rates significantly reduces the level of consumption of non-durable goodsb. An increase in wealth has no effect on the level of consumptionC. The effects of interest rate changes on saving are small and hard to determined. An increase in interest rates significantly increases the level of savinge. None of the aboveDifficulty: Difficult44. When examining the impact of changes in the interest rate on saving, which of the following is true?a. Higher interest rates may make saving more attractiveb. Higher interest rates allow individuals to save less each year to reach their retirement saving goalc. Empirical evidence does not suggest that interest rate changes significantly affect saving D. All of the abovee. None of the aboveDifficulty: Medium45. In the Fisher diagram, which gives a microeconomic explanation of why an increase in the rate of interest (i) can lead to either an increase or a decrease in current consumption, the budget constraint can be formulated asA. C later = (1 + i) (Y now - C now)b. C later = (1 + i) (Y later - Y now)c. C later = i (Y now - C now)d. C later = (Y now - C now)/ (1 + i)e. C later = (Y now - C now)Difficulty: Difficult46. Any policy designed to increase business saving will most likelya. Not affect national saving since personal saving will decline proportionallyb. Not affect national saving since the resulting budget deficit will reduce government saving C. Increase national saving since personal saving will decrease by less than the increase in business savingd. Reduce national saving since personal saving will decrease by more than the increase in business savinge. Reduce national saving due to the decline in personal and government savingDifficulty: Medium47. The Barro-Ricardo equivalence propositiona. States that debt-financing merely postpones taxation and therefore in many instances is equivalent to current taxationb. Relies on the absence of liquidity constraints and the presence of an operational bequest motivec. Implies that a cut in current taxes that carries with it an implied increase in future taxes will lead to an increase in private savingd. Was not supported by events of the 1980s as taxes were cut, budget deficits increased, and private saving declinedE. All of the aboveDifficulty: Medium48. The proposition that financing debt by issuing bonds merely postpones taxation and is therefore in many instances equivalent to current taxation is known as thea. Balanced budget theoremb. Rational expectations propositionC. Barro-Ricardo equivalence propositiond. Reagan theory of taxatione. None of the aboveDifficulty: Easy49. The Barro-Ricardo equivalence proposition relies ona. The presence of an operational bequest motiveb. The absence of liquidity constraintsc. The presence of liquidity constraintsD. Both A and Be. Both A and CDifficulty: Medium50. The Barro-Ricardo equivalence proposition implies that tax cutsa. Always lead to a reduction in the budget deficitb. Always lead to the crowding out of investment spendingC. That lead to higher budget deficits do not stimulate consumption since people will save in anticipation of future tax increasesd. Provide important incentives for economic growthe. Ease people's liquidity constraints so they consume moreDifficulty: Medium。
Chapter 13Solutions to the Problems in the Textbook:Conceptual Problems:1.a. According to the life-cycle theory of consumption, people try to maintain a fairly stable consumption pathover their lifetime. Individuals save during their working years so they can keep up the same consumption stream after they retire. This implies that wealth increases steadily until retirement while consumption remains stable. We should therefore expect the ratio of consumption to accumulated saving (wealth) to decrease over time up to retirement.1.b. After retirement, wealth is used up to finance consumption during the remaining years. Therefore the ratioof consumption to accumulated saving (wealth) increases again after retirement, eventually approaching 1.2.a. Suppose that you and your neighbor both work the same number of years until retirement and you bothhave the same annual income. If your neighbor is in bad health and does not expect to live as long as you do, she will expect to have fewer retirement years in which to use accumulated wealth to finance a steady consumption stream. Your neighbor's goal for retirement saving will not be as high as yours, and compared to you, she will have a higher level of consumption over her working years.Since planned annual consumption (C) is determined by the number of working years (WL), the number of years to live (NL), and income from labor (YL), we get the equation:C = [(WL)/(NL)](YL).WL and YL are the same for you and your neighbor, but NL is smaller for your neighbor. Therefore you will have a lower level of consumption (C).(Note: Students may come up with a variety of different answers. For one, your neighbor, who is in bad health, currently has much larger medical bills than you do. Therefore she may not be able to save as much for retirement, even if she might expect to live as long as you. On the other hand, she may not have large medical bills now, but expects them later, as she gets older. This may induce her to save more now.While such arguments are valid, instructors should point out that the answer should be related to the life-cycle theory.)2.b. If we assume for simplicity that the rate of return on Social Security is the same as the rate of return onprivate saving, then the introduction of a Social Security system based on a trust fund should not have any effect on your level of consumption. Social Security may be considered a form of "forced saving," since you are forced to pay Social Security taxes during your working years and will, in return, receive benefits during your retirement years. However, most likely you would have voluntarily saved as much as the government is now “forcing” you to save with levying a Social Security tax. Therefore your consumption behavior will not change. Still, the levying of a Social Security tax reduces disposable income during your working years, increasing the ratio of consumption to disposable income (the average propensity to consume). If private saving were simply replaced with government saving, national saving would not be affected.In reality, however, the Social Security system is not strictly financed through a trust fund, but largely on a pay-as-you-go basis. The size of the Social Security trust fund was fairly insignificant until the system was amended in 1983. Now the trust fund is increasing and, in effect, contributing to the federal budget surplus. But because of our aging population, predictions are that the Social Security system will experience severe financial difficulties within the next 20-30 years. If the credibility of the system becomes an issue, people may intensify their saving efforts, since they no longer feel they can rely on the1public system to provide for them during retirement. In the past, most of the Social Security taxes were not "saved" but immediately used by the government to finance the benefits of the current retirees. This is why most economists claim that the Social Security system has led to a decrease in the national savings rate and a decrease in the rate of capital accumulation. The magnitude of this decrease, however, has not been clearly established.3.a. If you get a yearly Christmas bonus, you immediately treat it as part of your permanent income and spendit accordingly, that is, ∆C = c(∆Y). In other words, your current consumption will change significantly. 3.b. If you get a Christmas bonus for only this year, you will consider it as transitory income. Since yourpermanent income is hardly affected, you will consume only a small fraction of it and save the rest. In other words, your current consumption will not be significantly affected.4. Gamblers (or thieves) seldom have a very stable income. However, their consumption is determined bytheir permanent income, that is, their expected average lifetime income. Whether they have a large or small income during any given period, their consumption pattern remains relatively stable, since their permanent income is not significantly affected by temporary changes in earnings.5. Both theories, in their own way, try to explain why the short-run mpc is smaller than the long-run mpc.The life-cycle theory attributes the difference to the fact that people prefer a smooth consumption stream over their lifetime. Therefore the average expected lifetime income is the true determinant of current consumption. The permanent income theory suggests that the difference is due to measurement errors.Measured income has two components, that is, permanent and transitory income. But only permanent income is a true determinant of current consumption.6.a. One possible explanation could be that the “baby boomers” were still in their dissaving phase. In otherwords, if households of the baby boom generation still had to buy houses or pay for expenses related to childcare in their late twenties, they may not have been able to save for retirement yet.6.b. If the above explanation is correct, one can expect an increase in saving as these “baby boomers” age,become more financially solvent, and begin to prepare for retirement.7. The ranking from highest to lowest value should be first (a), then (d), and then (b). Clearly, (c) shouldbe lower than (a), but where exactly it ranks after that depends largely on the severeness of the liquidity constraint.8. A series follows a random walk when future changes cannot be predicted from past behavior. In otherwords, it does not have a mean or clear long-run value. Any major change comes about because of random shocks. Hall asserted that changes in current consumption largely come from unanticipated changes in income. According to the life-cycle theory or permanent-income theory, people try to smoothen out their consumption stream in such a way that its expected value is always the same in each period. Therefore, we can express future consumption as the expected value plus some error term, that is, some random value that is unpredictable. This error term is a shock to future income that is spread over the remaining lifetime.Hall supported the permanent-income hypothesis by showing that lagged consumption is the most2significant determinant of future consumption.9. The problem of excess sensitivity means that consumption responds more strongly to predictable changesin current income than the life-cycle theory and permanent-income theories predict. The problem of excess smoothness means that consumption does not respond as strongly to unpredictable changes in current income as these theories predict. However, the existence of these problems does not invalidate the theories.It simply means that the theories can explain consumption behavior only to a certain degree.10. Precautionary (or buffer stock) saving can be explained by uncertainty. It could be uncertainty in regardto one’s life expectancy or one’s time of retirement (af fecting the accumulated saving needed to finance retirement), or uncertainty about future spending needs (which may be caused by a change in family composition or health). Clearly, if we account for such uncertainties, we bring the model much closer to reality. For example, many elderly still continue to save after retirement in anticipation of predicted high medical costs not covered by Medicare.11.a. It is unclear whether an increase in the interest rate leads to an increase or a decrease in saving. On the onehand, as the interest rate increases, the return on saving increases and people may therefore increase their savings effort (due to the substitution effect). On the other hand, a higher return on saving implies that a given future savings goal can now be reached with a smaller savings effort in each year (due to the income effect).11.b. The income effect and the substitution effect generally tend to go in different directions, and the overalloutcome depends on the relative magnitude of these two effects. Until now, empirical evidence has not established a significant sensitivity of saving to changes in the interest rate. This would imply that the income and the substitution effects have about the same magnitude.12.a. According to the Barro-Ricardo hypothesis, it does not matter whether an increase in government spendingis financed by taxation or by issuing debt.12.b. The Barro-Ricardo hypothesis states that people realize that government debt financing by issuing bondssimply postpones taxation. In other words, people know that the government will have to raise taxes in the future to pay back what they have borrowed now. Therefore, expansionary fiscal policy that results in an increase in the budget deficit will no stimulate the economy since it will lead to an increase in saving rather than consumption. People want to be prepared to pay future taxes.12.c. There are two main objections to the Barro-Ricardo hypothesis. One is based on liquidity constraints, thatis, people may want to consume more but may not be able to borrow as much as they like. Therefore, if there is a tax cut, they will consume more, rather than save the tax cut. The other argument is that those people who benefit from a tax cut or an increase in government spending are not the same as those who will have to pay the higher taxes to pay off the debt. This argument assumes that people are not concerned about the welfare of their descendants.Technical Problems:1.a. If income remains constant over time, permanent income equals current income. Your permanent income3this year is YP0 = (1/5)(5*20,000) = 20,000.1.b. Your permanent income next year is YP1 = (1/5)(30,000 + 4*20,000) =1.c. Since C = 0.9YP, your consumption this year is C0 = 0.9*20,000 = 18,000.Your consumption next year is C1 = 0.9*19,000 = 17,100.1.d. In the short run, the mpc = (0.9)(1/5) = 0.18; but in the long run, the mpc = 0.9.1.e. We have already calculated this and next year's permanent income. In each of the coming years you add$30,000 and subtract $20,000, and therefore your permanent income (which is your average over a five year period) will increase by $2,000 each year until it reaches $30,000 after 5 years.YP o = (1/5)(5*20,000) = 20,000YP1 = (1/5)(1*30,000 + 4*20,000) = 22,000YP2 = (1/5)(2*30,000 + 3*20,000) = 24,000YP3 = (1/5)(3*30,000 + 2*20,000) = 26,000YP4 = (1/5)(4*30,000 + 1*20,000) = 28,000YP5 = (1/5)(5*30,000) = 30,000Y30,00028,00026,00024,00022,00020,0000 1 2 3 4 5 time2.a. The person lives for NL = 4 periods and earns a lifetime income ofYL = 30 + 60 + 90 + 0 = 180.Therefore consumption in each period will be C i = (1/4)180 = 45, i = 1, 2, 3, 4.This implies that saving in each period is:S1 = 30 - 45 = - 15; S2 = 60 - 45 = + 15; S3 = 90 - 45 = + 45; S4 = 0 - 45 = - 45.2.b. If liquidity constraints exist and the person cannot borrow in the first period, then she will consume all ofher income, that is, Y1 = C1 = 30.For the remaining three periods the person wants a stable consumption stream. Thus she will consume C(i) = (1/3)(60 + 90 + 0) = 50 in each of the remaining three periods i = 2, 3, 4.42.c. An increase in wealth of only $13 is not enough to offset the difference in consumption patterns betweenperiod 1 and the other periods. Therefore all of the increase in wealth will be consumed in period 1, such that C1 = 43. In the remaining three periods, consumption will be the same as in 2.b.An increase in wealth of $23 will be enough to offset the difference in consumption patterns. Lifetime consumption in each period will now be C i = (1/4)(180 + 23) = 50.75. This means that 20.75 (or almost all of the additional wealth) will be used up in the first period; the remaining 2.25 will be distributed over the next three years.3.a. According to the life-cycle theory and permanent income hypothesis (LC-PIH), the change in consumptionequals the surprise element, that is, ∆C LC-PIH= ε. According to the traditional theory, the change in consumption equals ∆C tr = c(∆YD). Therefore if a fraction λ of the population behaves according to the traditional theory and the other fraction behaves according to LC-PIH, then the total change in consumption is∆C = λ(∆C tr) + (1 - λ)(∆C LC-PIH) = λc(∆YD)+ (1 - λ)cε = (0.7)(0.8)10 + (0.3)ε = 5.6 + (0.3)ε3.b. ∆C = (.3)(.8)10 + (.7)ε = 2.4 + (.7)ε3.c. ∆C = (0)(.8)10 + 1ε = ε4.a. If the real interest rate increases, the opportunity cost of consuming should increase. Therefore, theaverage propensity to save, that is, the fraction of total income that is saved, should increase.4.b. If you only save for retirement and your savings goal is fixed, then you actually will save less. With ahigher interest rate it will take less saving each year to achieve your goal.4.c. The first case (4.a.) describes the substitution effect, whereas the second case (4.b.) describes the incomeeffect. Unless the magnitude of each of these effects is known, we cannot predict the overall effect of this interest rate increase on saving.5. One way to increase saving would be to either privatize or eliminate the Social Security system, so peoplewould have to save for retirement on their own. (Eliminating Social Security is not a very popular measure, but the privatization of Social Security is often discussed.) This would do away with the negative effect on saving that comes from the pay-as-you-go nature of financing Social Security. Another way might be to make it more difficult to borrow. The U.S. tax system encourages people (and firms) to borrow rather than save.5Additional Problems:1. As a share of GDP, how large is consumption compared to the other three main components.Would you expect consumption's share to increase or decrease in a recession?Consumption expenditures are roughly two thirds of total GDP, which is higher than the other three components (investment, government purchases, and net exports) taken together. The ratio of consumption to GDP, however, does not always remain constant. In a recession, for example, when income is below trend, we should expect the consumption-to-GDP ratio to increase, while in a boom, when income is above trend, we should expect the ratio to decrease. The reason is that current consumption is based on permanent rather than current income and when current income is greater than permanent income, the ratio of consumption to income (the apc) goes down. This argument is reinforced by the concept of automatic stability. When GDP falls, personal disposable income falls by less and thus consumption does not fall dramatically.2. True or false? Why?"The marginal propensity to consume out of transitory income is greater than the marginal propensity to consume out of permanent income."False. The permanent-income hypothesis argues that consumption is related to permanent disposable income. Individuals will only revise their consumption behavior significantly if they perceive a change in income as permanent. Very often people are uncertain as to whether a rise in income is permanent or transitory, so they do not significantly revise their consumption patterns immediately. This suggests a lower marginal propensity to consume out of transitory income than out of permanent income.3. Do you think that the marginal propensity to consume out of current income would differ betweentenured professors who have a high degree of job security and professional gamblers who never know when luck will strike?Tenured professors have a high degree of job security and their income does not vary a great deal. They can therefore relatively accurately estimate their permanent income. This means that their current consumption is largely based on current income, implying that their short-run mpc is fairly high. Gamblers, on the other hand, never know what their income in any given year is going to be. Therefore, they base their consumption decisions on their average expected lifetime income (permanent income) rather than on current income. This implies that their short-run mpc is fairly low.4. Is the short-run marginal propensity to save different between farmers and government employees?Why or why not?Government employees generally have very stable incomes and high job security. Therefore they base their consumption decision to a large extent on current income so their short-run mpc is high, while their short-run mps is low. Farmers, on the other hand, have highly variable incomes, depending on weather conditions. Therefore they tend to base their consumption decisions on their permanent income. Their short-run mpc is low, while their short-run mps is high.5. "If most people base their consumption decisions on their current rather than their permanentincome, then the short-run multiplier is greater than the long-run multiplier." Comment on this6statement.If most people follow the traditional theory and base their consumption decisions mostly on current income, then their mpc out of current income is high, making the value of the short-run multiplier high. But if most people follow the permanent-income theory and base their consumption decisions primarily on permanent income, then the short-run mpc is low, making the value of the short-run multiplier low. In either case, as long as some people follow the permanent-income theory, then the short-run multiplier should always be smaller than the long-run multiplier.6. Assume you define your permanent income as the average of this and the past four years’ incomesand you always consume 4/5 of your permanent income. Your earnings record over these years has been: Y t= 40,000, Y t-1 = 38,000, Y t-2 = 34,000, Y t-3 = 32,000, Y t-4 = 31,000.If next year your income increases to Y t+1= 46,000, by how much will your consumption change between year t and year t+1?YP t= (1/5)(40,000 + 38,000 + 34,000 + 32,000 + 31,000) = (1/5)175,000 = 35,000C t= (4/5)YP t = (4/5)35,000 = 28,000YP t+1 = (1/5)(46,000 + 40,000 + 38,000 + 34,000 + 32,000) = (1/5)190,000 = 38,000C t+1 = (4/5)YP t+1 = (4/5)38,000 = 30,400Therefore your consumption will change by C = 2,400.7. Assume a distant aunt gives you several thousand dollars and you use the money to pay back part ofyour student loan. Does your behavior correspond to the prediction of the permanent-income theory?Why or why not?Paying back your debts actually can be seen as an act of "saving." Therefore, since you use some unexpected income to save (rather than consume), your behavior fits the permanent income theory nicely.8. "Early retirement raises aggregate consumption." Comment on this statement.Early retirement reduces lifetime income and increases the length of retirement. The life-cycle model states that individuals consume on the basis of their average lifetime income to maintain a stable consumption path throughout their lives. In an economy with a constant population and no technological progress, aggregate consumption will fall if retirement age drops because people who retire earlier have to accumulate funds for more retirement years over fewer working years. As this can only be accomplished with greater saving, consumption has to be reduced.However, if the population is growing and retirement benefits are financed through taxes levied on workers currently employed, then aggregate consumption may actually rise. In this case, the working population will be paying for the reduction in lifetime earnings experienced by those who have retired early, and there is less need for retirement saving.9. The simple life-cycle hypothesis predicts that people save over their working years but dissave7during their retirement years. Do we actually observe such behavior? If not, can you explain why not?Most elderly actually do not dissave, but they do save less than they did during their working years. One of the reasons that the elderly still save may be the fact that they anticipate large medical bills as they grow older and therefore prefer to keep a certain buffer stock of saving. The elderly may also hope to leave some of their savings as bequests to their children or grandchildren.10. On October 19, 1987, the Dow Jones industrial average dropped about 500 points, or a little morethan 23%. What effect should a decline in stock values of this magnitude have had on aggregate demand according to the life-cycle theory of consumption?According to the life-cycle theory, any change in wealth should affect consumption behavior. The decline in stock values constituted roughly a $500 billion decline in wealth. However, we did not see a huge decrease in consumption in 1987, since the wealth effect tends to be fairly small. In addition, the Fed reacted promptly, announcing that liquidity would be provided if needed.11. Does the random walk model of consumption disprove the permanent income hypothesis? Why orwhy not?Robert Hall tried to disprove the permanent income theory by applying the concept of rational expectations to the theory of consumption. He asserted that consumption patterns may follow a random walk, that is, changes in consumption may come from unanticipated changes in income. However, by concluding that lagged consumption is the most significant determinant of future consumption, Hall actually supported the predictions of the permanent-income hypothesis.12. How is Hall’s random walk model of consumption related to the permanent-income hypothesis andwhat are the implications of these theories for fiscal policy?Hall asserted that changes in current consumption largely come from unanticipated changes in income. Any major change in consumption comes about because of random shocks. According to the permanent-income theory, people try to smoothen out their consumption stream in such a way that its expected value is always the same in each period. Therefore, we can express future consumption as the expected value plus some error term, that is, some random value that is unpredictable. This error term is a shock to future income that is spread over the remaining lifetime. Hall supported the permanent-income hypothesis by showing that lagged consumption is the most significant determinant of future consumption. The implication for fiscal policy is that a temporary tax change will not significantly affect current consumption, unless there are liquidity constraints.13. True or false? Why?"A temporary tax surcharge never has a significant effect on current consumption."False. If individuals know that the tax surcharge is temporary they will not alter their spending patterns as the tax change has little impact on their permanent income. However, when liquidity constraints exist, individuals may be forced to adjust their consumption behavior immediately. If individuals barely earn enough to finance their current consumption, for example, they may be forced to cut their current consumption if a temporary tax surcharge is levied.814. "As a response to a temporary increase in personal and corporate income taxes consumers willreduce their spending and firms will cut production and increase prices. Therefore all we will get is stagflation, that is, an increase in both unemployment and inflation, and tax revenues won't increase." Comment on this statement.The life-cycle/permanent-income theory of consumption predicts that temporary changes in income will not significantly affect the level of consumption. Thus a temporary tax surcharge should not significantly affect aggregate demand. A similar argument can be made about firms, since changes in production are often costly and therefore a temporary surcharge on corporate income taxes should not affect the level of output and prices. The levels of national income and prices should not be affected significantly but we should see a (temporary) increase in tax revenues due to the surcharge. (Note, however, that if consumers and firms face liquidity constraints, they may react to a temporary surcharge in the way described in the statement.)15. "Any tax cut that results in an increase in the budget deficit will fail to stimulate aggregatedemand." Comment on this statement. In your answer explain the effect of such a tax cut on interest rates, money supply, and private domestic saving.The Barro-Ricardo proposition states that a tax cut that results in a budget deficit increase leads to higher saving. Since people will anticipate a future tax increase to finance the higher deficit, permanent income will not be affected. Thus consumption will not be affected; instead people will save the tax cut. Since this is purely a fiscal policy measure, money supply is not affected. The increase in the budget deficit will lead to higher interest rates due to the increased demand for credit. (Note that evidence from the 1980s does not support this hypothesis. The Reagan tax cuts in 1981 resulted in a large increase in the budget deficit but there was no subsequent increase in saving.)916. Assume the government announces plans for fiscal expansion that are likely to result inincreased government borrowing. What effect should this have on aggregate consumption, money supply, the income velocity of money, the trade deficit, and savings?The Barro-Ricardo proposition states that if fiscal expansion results in a budget deficit, the public will anticipate a future tax increase to finance the deficit. They believe that their permanent income will not be affected and choose to save rather than consume more. Therefore, we should expect an increase in private saving but no significant change in consumption. Thus there is no significant change in national income and, since this is solely a fiscal policy, money supply is also not affected. Therefore there is no change in the income velocity. The trade deficit may also not be significantly affected, since domestic saving supports the budget deficit. However, evidence from the 1980s does not lend support for this hypothesis. Saving did not increase after the Reagan tax cuts that resulted in a huge increase in the budget deficit. Instead, we saw an increase in consumption and the trade deficit, since higher interest rates caused an inflow of funds, leading to an appreciation of the U.S. dollar. The income velocity also increased, due to the increase in economic activity.10。
