ch13 - CHAPTER 13 CONSUMPTION AND SAVING Solutions to the...

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CONSUMPTION AND SAVING Solutions 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 path over 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 ratio of 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 both have 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 on 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 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. 1
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ch13 - CHAPTER 13 CONSUMPTION AND SAVING Solutions to the...

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