Intermediate Macroeconomics Sample Problems
		10. Consumption

Contents

1. Keynesian Consumption Function

1. If the Keynesian consumption function is of the form C = C₀ + c * YD, where YD = disposable income, then
   1. the marginal propensity to consume (MPC) increases with increases in the level of disposable income
   2. the average propensity to consume (APC) is constant at all levels of disposable income
   3. the APC increases with increases in the level of disposable income
   4. the MPC is constant at all levels of disposable income

   Answer: d. With the Keynesian consumption function the marginal propensity to consume is constant and the average propensity to consume declines as income increases. If answer c had been written, the APC decreases..., then it would also have been a correct answer.

3. Life Cycle Hypothesis

1. The two basic assumptions life-cycle theory of consumption are that people prefer a stable level of consumption throughout their lives and
   1. will forego temporary or transitory opportunities to obtain higher income and consumption
   2. calculate their level of consumption from the information they have regarding their average expected lifetime income
   3. spend more on durable goods than nondurable goods or services
   4. always save the same fraction of their current income

   Answer: B. Knowing the average level of income allows a person to estimate total lifetime income. An expectation of lifetime income allows a person to plan a stable level of consumption.

2. According to the life cycle/permanent income theories, which of the following would have the greatest impact on the current consumption of a 30-year-old government worker:
   1. an unexpected promotion with a $2,000 a year raise
   2. winning $3,000 in the lottery
   3. $2,000 inheritance from a forgotten relative
   4. choices (A) and (C), since they have equal effects

   Answer: A. This question requires understanding how the marginal propensity to consume is calculated given an expected permanent change in income (A) or a temporary change in income (B and C). The MPC out of a temporary change in income is 1 divided by number of years expected to live. The MPC out of a permanent change in income is the number of years working divided by the number of years expected to live. The MPC out of a permanent change in income is much larger than the MPC out of a temporary change in income. Thus, even though the current period change in income is larger in answer (B), the affect on current period consumption is much larger for answer (A).

3. Answer the following questions using the Life Cycle model for a typical consumer with the following expectations:

   Worker's current age	35
   Life expectancy (age at death)	75
   Expects to work until age	65
   Accumulated wealth today	$200,000
   Expected annual average income while working	$36,000

   The worker described in the table above wants a stable level of consumption throughout life and leave no estate. How much per year would you expect this person to consume?

   Answer:

   Total current wealth + expected lifetime income = $200,000 + 30 years x $36,000 = $1,280,000
   Divided by life expectancy, 40 years
   Equals average annual consumption = $32,000

   Additional questions could be asked such as , if this worker unexpectedly won a $100,000 lottery, what would annual consumption now be? ($32,000 + $100,000/40 years = $34,500). What is the marginal propensity to consume out of a temporary change in income? (1/expected lifetime = 1/40 = 0.025), and so on.

File last modified: April 4, 2004

© Tancred Lidderdale (Tancred@Lidderdale.com)