Question

If consumption is determined by the permanent income then we should expect higher marginal propensity to consume in the long run than in the short run’. True or false? Explain.

Answer 1

This statement is true. The permanent income hypothesis states that consumption not only depends upon temporary income or transitory income but it also depends upon permanent income. Therefore there is a correlation between permanent income and permanent consumption. MPC is constant in the long run and is equal to APC. In the short run however if the transitory income is increased by a larger amount then consumption smoothing will result in an increase in consumption by a small amount so that the MPC will be smaller in the short run.