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In: Economics

Briefly explain whether each of the following statements is true or false. 5. The permanent income...

Briefly explain whether each of the following statements is true or false.

5. The permanent income theory of consumption predicts that saving responds less to permanent changes in income than temporary changes in income.

Please include a detailed explanation with graphs.

Solutions

Expert Solution

The Statement in question is true.

As Permanent income theory of consumption, consumption respond more to permanent changes of income rather than temporary changes. And as we know that Income = Savings + Consumption, therefore savings will respond less due to permanent changes in income and more to temporary changes in income (as if there is any changes in income happens in short term individuals saves the additional money therefore changes savings much in short term).

As it can be seen in the diagram, due to increase in income from Y1 to Y2, C sr increased from Eo to E1, while the same level of income increase has led to more increase in comsumption from Eo to E2.

As, Income = Savings + Consumption.

In short run,

More change in Income = More change in savings (as consumers will save those windfall money) + Less change to consumption

In long run,

More change in income = Less change in savings (as individuals will return to old saving habits and increase consumption) + More change in consumption.

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Rahul Sunny answered 2 years ago
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