The University of the West Indies, St.

Augustine
Department of Economics

ECON 2003: Intermediate Macroeconomics II

Tutorial Sheet # 51

1. What is the difference between Modigliani's life-cycle hypothesis and the

Keynesian consumption function?

ANSWER:

The Keynesian consumption function states that consumption is only affected by current
income. The life-cycle hypothesis states that consumption is based upon a person's lifetime
resources, composed of wealth and lifetime earnings.

2. Use Fisher’s model of consumption to analyze an increase in second-period

income. Compare the case in which the consumer faces a binding borrowing
constraint and the case in which he does not.

ANSWER:

Fisher’s model of consumption looks at how a consumer who lives two periods will make
consumption choices in order to be as well off as possible. Figure 17–1(A) shows the effect
of an increase in second-period income if the consumer does not face a binding borrowing
constraint. The budget constraint shifts outward, and the consumer increases consumption
in both the first and the second period. In Figure 17-1(A), Y1 is the first period income and
Y2 is second period income. In choosing to consume at point A or B, the consumer is
consuming more than their income in period 1 and less than their income in period 2.

1
Academic Year: 2013/2014
Note to students: Based on Chapter 17,18
Figure 17-1 (A)

Figure 17–2 shows what happens if there is a binding borrowing constraint. The
consumer would like to borrow to increase first-period consumption but cannot. If
income increases in the second period, the consumer is unable to increase first-period
consumption. Therefore, the consumer continues to consume his or her entire income
in each period. That is, for those consumers who would like to borrow but cannot,
consumption depends only on current income.

Figure 17-2
3. How do the life-cycle and permanent income hypotheses resolve the seemingly
contradictory pieces of evidence regarding consumption behavior?

ANSWER:

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.

The life-cycle hypothesis stresses that income varies over a person’s life; saving allows
consumers to move income from those times in life when income is high to those times
when it is low. The life-cycle hypothesis predicts that consumption should depend on both
wealth and income, since these determine a person’s lifetime resources. Hence, we expect
the consumption function to look like

C = αW + βY.

In the short run, with wealth fixed, we get a “conventional” Keynesian consumption
function. In the long run, wealth increases, so the short-run consumption function shifts
upward, as shown in Figure 17–1.

The permanent-income hypothesis also implies that people try to smooth consumption,
though its emphasis is slightly different. Rather than focusing on the pattern of income over
a lifetime, the permanent-income hypothesis emphasizes that people experience random
 and temporary changes in their income from year to year. The permanent-income
hypothesis views current income as the sum of permanent income Y p and transitory
income Yt . Milton Friedman hypothesized that consumption should depend primarily on
permanent income:

C = α YP
The permanent-income hypothesis explains the consumption puzzle by suggesting that the
standard Keynesian consumption function uses the wrong variable for income. For
example, if a household has high transitory income, it will not have higher consumption;
hence, if much of the variability in income is transitory, a researcher would find that high-
income households had, on average, a lower average propensity to consume. This is also
true in short time series if much of the year-to-year variation in income is transitory. In
long time-series, however, variations in income are largely permanent; therefore,
consumers do not save any increases in income, but consume them instead.

4. Use the neoclassical model of investment to explain the impact of each of the
following on the rental price of capital, the cost of capital, and investment.
a. Anti-inflationary monetary policy raises the real interest rate.
b. An earthquake destroys part of the capital stock.
c. Immigration of foreign workers increases the size of the labor force.

ANSWER:

In answering parts (a) to (c), it is useful to recall the neoclassical investment function:
I = In[MPK – (PK/P)(r + δ)] + δK.

This equation tells us that business fixed investment depends on the marginal product of
capital (MPK), the cost of capital (PK/P)(r + δ), and the amount of depreciation of the
capital stock (δK). Recall also that in equilibrium, the real rental price of capital equals the
marginal product of capital.
a. The rise in the real interest rate increases the cost of capital (PK/P)(r + δ).
Investment declines because firms no longer find it as profitable to add to their
capital stock. Nothing happens immediately to the real rental price of capital,
because the marginal product of capital does not change.
b. If an earthquake destroys part of the capital stock, then the marginal product of
capital rises because of diminishing marginal product. Hence, the real rental price of
capital increases. Because the MPK rises relative to the cost of capital (which does
not change), firms find it profitable to increase investment.
c. If an immigration of foreign workers increases the size of the labor force, then the
marginal product of capital and, hence, the real rental price of capital increase.
Because the MPK rises relative to the cost of capital (which does not change), firms
find it profitable to increase investment.

5. Fill in the blanks:

marginal propensity to consume marginal rate of substitution
permanent income permanent-income hypothesis
income effect indifference curve
intertemporal budget constraint substitution effect
transitory income production smoothing
Tobin’s q neoclassical model of investment
inventories as a factor of production efficient markets hypothesis
stock-out avoidance work in process

a. The amount that an individual consumes out of an additional dollar of

(disposable) income is called the ________________________.

b. When consumers are deciding how much to consume today versus how much
to save for future consumption, they face a(n) ____________________________________.

c. In Irving Fisher’s model of consumption, a(n) ________________________________ shows

the combinations of first-period consumption and second-period consumption
that make the consumer equally happy.

d. The slope of the indifference curve equals the ___________________________________,

which represents the amount of second-period consumption the consumer
requires to be compensated for a one-unit reduction in first-period
consumption.

e. When the real interest rate changes, the change in consumption can be
divided into two components. The change in consumption resulting from the
movement to a higher indifference curve is called the
_______________________________. The change in consumption arising from the change
in the relative price of consumption between different periods is called the
_______________________________________.

f. The _______________________________________ distinguishes between two types of

income that affect consumption. ________________________________________ is the part of
income that people expect to persist in the future. The part of income that
people do not expect to persist is called ________________________________.

g. The __________________________________________________________________ examines the

benefit and cost to firms of owning capital goods by showing how investment
is related to the marginal product of capital, the interest rate, and the tax rules
affecting firms.
 h. According to one theory of investment, firms base their investment decisions
on the ratio of the market value of installed capital divided by the replacement
cost of installed capital. This ratio is known as
_____________________________________________________.

i. According to the __________________________________________________________________, the

price of a company’s stock is the fully rational valuation of that company’s
value, given current information about the company’s business prospects.

j. Firms have several motives for holding inventories. One motive, called
___________________________________, exists when it is cheaper for a firm to produce
goods at a steady rate when that firm experiences temporary booms and busts
in sales. Firms can also view ____________________________________________ when
inventories increase output by improving efficiency. A third motive, called
______________________________________, exists when firms hold inventories to avoid
running out of goods when sales are unexpectedly high. A final motive exists
because many goods take time to produce, so they are counted as part of a
firm’s inventory when they are only partly completed. These inventories are
called _____________________________________.

ANSWERS:

a. marginal propensity to consume

b. intertemporal budget constraint

c. indifference curve

d. marginal rate of substitution

e. income effect; substitution effect

f. permanent-income hypothesis; permanent income; transitory income

g. neoclassical model of investment

h. Tobin’s q

i. efficient markets hypothesis

j. production smoothing; inventories as a factor of production; stock-out avoidance; work in

process