Question

Chapter 16: Briefly explain the “Consumption Puzzle”. What solutions have been proposed to solve it and to what extent they have been successful? Discuss.

Chapter 17: Briefly explain the “efficient markets hypothesis”. What criticisms have been levelled against it? Discuss.

Chapter 18: Should policy be active or passive? Discuss by considering alternative perspectives

Answer 1

Answer 16- In economics, the theory on consumption for the first time was given by Johnn Maynard Keynes. He put forwarded 3 conjectures about the consumption function-

1. MPC lies between 0 and 1.

2. APC falls as income rises.

3.Income is the primary determinant of consumption and not interest rate.

During that time, there were not any sophisticated techniques of consumption data analysis. Later on, when some economist conducted research using computers the sophisticated techniques, they found that Keynes theory hold only for short run. In long run Keynes conjectures that APC falls as income rises and income was the primary determinant for consumption didn’t hold true. Simon Kuznets analysed the data on consumption and income in 1869 and found that the APC is fairly constant over long period of time. This contradictory results are known as the Consumption puzzle.

To solve the consumption puzzle two economists Franco Modigliani and Milton Friedman have put forwarded two of their Hypothesis

1.“Life cycle Hypothesis” and

2.“Permanent Income Hypothesis”

Franco Modigliani's “Life Cycle Hypothesis” says that any individual with wealth (w) and expected income (Y), earned throughout life till he/she retires (R) , he/she will divide up the lifetime resources among remaining years of life(T) and wish to achieve smooth consumption during the lifetime.

Through this hypothesis Modigliani solved the consumption puzzle with his argument that-wealth doesn’t vary proportionally with income from person to person or from year to year (high income means low propensity to consume and vice versa) over short periods of time. But over the long period, wealth and income grow together and as a result W/Y ratio remains constant.

According to Friedman's Permanent Income Hypothesis, consumption does not depend on income but only on the permanent income of the consumer. It solves the consumption puzzle by implying that APC depends only on the ratio of permanent income to current income. When current income rises (temporarily) above permanent income APC fall and vice versa.

With the help of these two hypothesis, the consumption puzzle has been solved with empirical evidences and sophisticated data analysis.