Question

How does the Life-Cycle Hypothesis resolve the puzzle of the Kuznet data?

	By assuming that income shows a life-cycle variation, the Life-Cycle Hypothesis is able to explain why short term MPC falls with income, but long-term APC is constant.
	By assuming that income is low in the early years and reaches a peak in late middle age and declines on retirement.
	By smoothing consumption over a lifetime.
	All of the above
	None of the above

Answer 1

By assuming that income shows a life-cycle variation, the Life-Cycle Hypothesis is able to explain why short term MPC falls with income, but long-term APC is constant.

KUZNETS PUZZLE.

Keynes studied about consumption using cross sectional data and Keynes proposed that

1. Marginal propensity to consume (MPC) ranges between to 1.

2. Average propensity to consume (APC) falls as income increases.

Kuznets studied the consumption function using time series data. And is concluded that there is no evidence for APC to fall as income increases. Instead APC remain constant.

These contradictory results on consumption function is called Kuznets puzzle.

Life cycle hypothesis.

It is formulated by Ando Modigliani.

According to this theory, Given the life span of an individual, his consumption depends on the money available with him. The proportion of money plans to spend depend on whether the spending plan is formulated during early or later stages of life. In the early stage of life, MPC would be high, as he has fewer money to spend. MPC is low during the middle age of the life, as his income would be high then. But average propensity to consume would remain constant or slightly increasing. Thus according to life cycle hypothesis APC shows an increasing trend over the time period.

Thus short run consumption is of life cycle hypothesis resembles Keynes proposition and Long run consumption function match with Kuznets proposition.