Answer to Question #191347 in Macroeconomics for ndinelago

Question

Explain how Life-Cycle Hypothesis and the Permanent Income Hypothesis, explain the difference between long run APC and short run APC.         

Answer 1

Solution:

The Life-Cycle Hypothesis is an economic theory that describes the spending and saving habits of people over the course of a lifetime. It stipulates that individuals aim to smooth consumption throughout their lifetime by borrowing when their income is low and saving when their income is high. On the other hand, Permanent Income Hypothesis stipulates that current consumption decisions are based on future income expectations. It states that individuals will spend money at a level that is consistent with their expected long-term average income.

 

The average propensity to consume (APC) measures the fraction of the total income that is spent on consumption or the fraction of the disposable income that is not saved. It is calculated by dividing the consumption by the total income.

Long run APC refers to an APC that remains constant with the changes in income. In the long run, changes in current income are attributable to changes in permanent income so that APC will remain constant. The long-run consumption function has a constant APC.

Short-run APC refers to an APC that falls with the changes in income. In the short run, it is the transitory income that changes so the APC falls when income rises. The short-run consumption function has a falling APC.