EP2 - Consumption Application

therobbdj's version from 2015-05-12 13:21


Question Answer
1964 Tax CutThe Kennedy Administration announced a "major and permanent reduction in tax rates". In the following years, growth rates increased (6.0% the year after) whilst unemployment fell. This phenomena appears to support Friedman's Permanent Income Hypothesis
1968 Tax SurchargeThe Johnson Administration announced a one-year increase in tax rates in order to reduce aggregate demand in the economy following excessive government spending following the Vietnam War. In the year, aggregate demand did not fall by much at all as unemployment fell and inflation rose. This phenomena appears to support Friedman's Permanent Income Hypothesis
2008 Economic Stimulus ActThe Bush Administration announced a one-time tax rebate to households, issued to households in the country at different times depending upon their Social Security Number. By comparing the consumer spending patterns of the consumers who had received their rebates and those who had not, it was found that consumers who had received their rebate consumed on average 50-90% of the quantity they had received. Whilst being good for the US economy, this contradicts Friedman's Permanent Income Hypothesis
Interwar PeriodIt was found that in this period, whenever income was unusually low (notably in the Great Depression), both consumer spending and saving was found to be low, whilst the consumption-income ratio (APC) was high. Furthermore, studies relating household consumption to household income found that households with greater incomes consumed and saved more than their low-income counterparts. Furthermore, richer households were found to save a larger fraction of their income, supporting the inverse relationship between income and APC. These phenomena support the Keynesian Consumption Function
Post World War IIOn the basis of the Keynesian Consumption Function, economists reasoned that as incomes in the economy grow, households would consume a smaller and smaller proportion of their income, meaning that there would be a lack of investment projects to absorb this increased saving, resulting in there being inadequate demand for goods and services in the economy, ultimately resulting in recession (i.e. secular stagnation). However, this phenomena did not occur: higher incomes did not lead to large increases in the rate of saving in the economy, implying a contradiction of the Keynesian Consumption Function
KuznetsAfter constructing aggregate data on US consumption and income for the period 1869-1940, it was found that the consumption-income ratio (APC) was remarkably stable from decade to decade despite there being large income increases. This implies that APC in the long-run is constant, thereby contradicting the Keynesian Consumption Function
Consumption PuzzleIn the short-run, the Keynesian Consumption Function is supported by data, however the function is contradicted in the long-run
Permanent Income Hypothesis: Rationality-Expectations AssumptionsThese state that consumers will utilise all information available to the in order to make optimal forecasts regarding the future (i.e. in order to smooth their consumption across their lifetime)
Random-Walk HypothesisBased upon the rationality assumptions, if the permanent income hypothesis is correct, changes in consumption over time should be unpredictable (i.e. they occur due to 'random events' such as an unexpected windfall, thereby affecting a consumer's transitory income)
Precautionary SavingWhen future income is uncertain, consumers are likely to undertake this in order to hedge against the possibility of a large drop in income (e.g. becoming unemployed). As a result, consumers may save a large fraction of their income even when income in the economy is low despite the permanent income hypothesis stating that consumers should instead borrow more money
2011 NMG Consulting Survey InformationDuring the recession, UK households states that they were uncertain about their future incomes and were expected to be influenced by the fiscal tightening, [but] did not expect to change the amount they saved. This supports the idea of precautionary saving within the economy. At the same time, consumption is expected to have fallen as VAT in the economy rose to 20%, supporting the Keynesian Consumption Function

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