AnswerToHW8[1] - CHAPTER 17 Consumption Questions for...

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Questions for Review 1. First, Keynes conjectured that the marginal propensity to consume—the amount con- sumed out of an additional dollar of income—is between zero and one. This means that if an individual’s income increases by a dollar, both consumption and saving increase. Second, Keynes conjectured that the ratio of consumption to income—called the average propensity to consume —falls as income rises. This implies that the rich save a higher proportion of their income than do the poor. Third, Keynes conjectured that income is the primary determinant of consump- tion. In particular, he believed that the interest rate does not have an important effect on consumption. A consumption function that satisfies these three conjectures is C = C + cY . C is a constant level of “autonomous consumption,” and Y is disposable income; c is the marginal propensity to consume, and is between zero and one. 2. The evidence that was consistent with Keynes’s conjectures came from studies of house- hold data and short time-series. There were two observations from household data. First, households with higher income consumed more and saved more, implying that the marginal propensity to consume is between zero and one. Second, higher-income households saved a larger fraction of their income than lower-income households, implying that the average propensity to consume falls with income. There were three additional observations from short time-series. First, in years when aggregate income was low, both consumption and saving were low, implying that the marginal propensity to consume is between zero and one. Second, in years with low income, the ratio of consumption to income was high, implying that the average propen- sity to consume falls as income rises. Third, the correlation between income and con- sumption seemed so strong that no variables other than income seemed important in explaining consumption. The first piece of evidence against Keynes’s three conjectures came from the fail- ure of “secular stagnation” to occur after World War II. Based on the Keynesian con- sumption function, some economists expected that as income increased over time, the saving rate would also increase; they feared that there might not be enough profitable investment projects to absorb this saving, and the economy might enter a long depres- sion of indefinite duration. This did not happen. The second piece of evidence against Keynes’s conjectures came from studies of long time-series of consumption and income. Simon Kuznets found that the ratio of con- sumption to income was stable from decade to decade; that is, the average propensity to consume did not seem to be falling over time as income increased. 3. Both the life-cycle and permanent-income hypotheses emphasize that an individual’s time horizon is longer than a single year. Thus, consumption is not simply a function of current income.
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AnswerToHW8[1] - CHAPTER 17 Consumption Questions for...

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