Question

Which of the following facts are consistent with forward-looking theories (LCH, PIH, and Random Walk) of consumption? Which are not? Justify your answer in each case. Where the facts are not consistent, can you suggest some alternative explanation? a. The MPC out of current income is less for old people than for middle-aged people. b. The MPC out of current income is less for farmers than for most of other occupations. c. The amount in wealth in the economy is far greater than what current wage earners will consume in their retirement. d. Across the population as a whole, people with lower incomes have lower saving rates than people with higher incomes.

Answer 1

Forward looking theories life cycle hypothesis and permanent income hypothesis life cycle hypothesis first of all we discuss life cycle hypotheses introduced by frenco modigliani 1950.A person income varies over his/her life they maintain their standard of living by saving when their income is high and spend it when they retiere. the life cycle framework continoes to be one of the most popular behavioural frame works within micro based models.This theory also known wealth theory of consumption this theory states that individuals seek to smooth consumption over the course of lifetime consumption is the function of life time expected income,wealth,and number of years until retirement.

permanent income hypothesis this theory is developed by milton friedman 1957 his theory is contradiction to long run proption and short run no-proportion consumption function. According to him current income into determinant of consumption expenditure.he divide consumption and income into permanent and transitory component.consumption of a person depend upon future expected income or permanent income only.

income=Y=Yp+Yt consumption C=Cp+Ct

APC or permanent consumption is independentor not depend on size of income. in long run MPC=APC

There is proportion relationship bw permanent income and consumption and it based on time series.

ASSUMPTIONS:1.There is no co-relationship between transitory income and permanent income 2.Only permanenet income effect the consumption 3.no correlation between transitory consumption and permanent consumtion.this is alternative explanation of hypothesis. marginal propensity to consumers is the porportion of an increase in income thar grts on consumption.mpc is determined by keynesian multiplier.A.MPC of poor is more than rich the mpc out of current income is less for old people than middle edged people because old people cost of their basic human need amount to a smaller fraction of this income and middle class peoples income is lower so their basic need is more .B.THE MPC out of current incme is less for farmers than for most of other occupatin because farmers income is lower than other occupations c.the amount in wealth iin the economy is for greater than what current wage earn will consume in their retirment because current income is more than retirement income.d.people with lower incomes have lower saving than people with higher income because their income is lower and their mpc is higher than higher income people so they can save lower amount and rich people consumption lawer than poor people.

MPS=Ratio of change in saving due to change in income ..

so people have lower income have lower saving rates than people have higher income.