Question

Assume you define your permanent income as the average of your disposbale income from the most recent five years. Your disposbale income record over these five years have been:

Y_?t= $50,000

Y_t-1=$45,000

Y_t-2=$40,000

Y_t-3=$38,000

Y_t-4=$30,000

A. If your income next year goes up to Y_t+1=$52,000, how much will your consumption change from this year to the next if C_p=0.9Y_p?

B. Suppose that the government increases income taxes for only one year. How will this affect aggregate consumption if 50% of the working population is liquidity constrained?

Answer 1

A. Given consumption function Cp=0.9Yp, the change in consumption due to change in income can be calculated:

Permanent income for current time period = (50000 + 45000 + 40000 + 38000 + 30000)/5

= $40,600

Current consumption = 0.9 (40,600)

=36,540

Permanent income for t+1 = (52000 + 50000 + 45000 + 40000 + 38000)/5

= 45,000

Conusmption for time t+1 = 0.9 (45,000)

= 40,500

Change in consumption = 40,500 - 36,540

= $3,960

B.

In the presence of liquidity constraits as a result of imposition of taxes, consumption will depend upon transitory income rather than permanent income for 50% of the population.

Therefore, Ct = 0.9 (Yt) rather than Yp.