Question

Describe the evidence about the response of household’s consumption to tax rebates in the U.S. Consider Friedman’s Permanent Income model or its extension with uncertainty (i.e., Hall’s random walk model). To which extent can this type of model explain that evidence? How could the model be amended to pro- vide a better explanation? Use the formal elements of the model (i.e., optimality conditions and budget constraints) and graphs as appropriate to support your discussion.

Answer 1

When there is a tax rebate that implies a temporary increase in income. so if we will go with Friedman's permanent income hypothesis, which explains consumption depends on a person's permanent income. Explaining it more, the consumption or the budget constraint of a person derived through the given amount of income. that represents you can't go for overconsumption or underconsumption if there is no temporary reason. Almost for all consumer, their consumption pattern is the same, unless he/she won't have any increase in income. so increase in income shifts the budget line right or if income comes down then it will shift down. so permanent income is the actual income of a person which may up or down temporarily by some gain or loss. so, in this case, there is a temporary gain due to the tax rebates. According to Friedman temporary gain or loss in a year doesn't impact the MPC of that year. so in this case consumption determined by the tax rebates. so there is a shift in the short-run consumption function. According to the random walk model by Hall, he had explained if a consumer is aware of the expected income growth then it will not change the consumption, but it is unexpected then it will change consumption. in present figure it has been expressed that the long-run consumption is constant, where the first position of equilibrium is E0. when there is an unexpected income flow is there it will shift the short-run consumption function to C2sr and accordingly the consumption increased with the increased disposable income from Y1 to Y2.

this case is a simple case of short-run increase in disposable income and that does not have any impact on MPC so the optimality can't be calculated with this short run increment. Here the budget constraint also not been affected by the change in unexpected income as this is temporary. the consumption will change for a short period but it has no impact on the permanent income line. so for this particular case, Friedman's permanent income hypothesis is the best model to explain.