Answer to Question #306042 in Macroeconomics for katrichie

Question

(a) Explain how Life-Cycle Hypothesis and the Permanent Income Hypothesis, explain the difference between long run APC and short run APC.(8)

(b) With a help of a diagram discuss how the permanent income theory of consumption explains the difference between the cross-section and time-series estimates of the Keynesian aggregate consumption function.(12)

Answer 1

a)

The life-cycle hypothesis is an economic theory that describes the spending and saving behavior of people over the course of a lifetime. The theory stipulates that individuals aim to smooth consumption in their entire lifetime through borrowing when their income is low and saving when their income is high. On the other hand, the Permanent income hypothesis states that current consumption decisions are based on future income expectations. Hence, individuals are likely to spend money at a level consistent with their expected long-run average income.

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

Long-run APC is an APC that remains constant despite the changes in income. In long run, the changes in current income can be linked to changes in the permanent income hence that APC will remain constant.

Short-run APC is an APC that falls with the changes in income. It can be argued that it is the transitory income that changes making the APC fall with an increase in income.

b)

In the cross-section, it puts into consideration the concepts of propensity to consume like; average propensity to consume and other marginal propensities to consume.

In the time series, the theory states that consumption depends on the level of income and how it changes over a period of time.