Questions: Consumption Determinants and the Consumption Function

Question 1

The government sends every household a one-time $1,200 tax rebate. According to the permanent income hypothesis, how will most households respond?

• A. They will spend nearly all of it immediately, since any income increase raises the optimal consumption level
• B. They will save most of it, since rational households smooth consumption over their lifetime and a temporary windfall barely changes permanent income
• C. They will spend exactly $1,200 because their marginal propensity to consume equals 1 for unanticipated windfalls
• D. They will spend none of it, because the permanent income hypothesis predicts zero response to any one-time transfer

Answer: (B)

The permanent income hypothesis (Friedman) holds that consumption is driven by permanent income — the expected long-run average — not current income. A one-time $1,200 rebate, spread over a remaining lifetime of 40 years, adds only about $30 per year to permanent income; spending should rise by roughly that amount, not $1,200. Households save the windfall to finance this small, sustained consumption increase. Empirically, responses to temporary transfers are larger than pure PIH predicts due to liquidity constraints, but the core insight stands: temporary income changes have muted consumption effects.

Question 2

If the marginal propensity to consume is 0.75, a $100 billion increase in government spending generates a total increase in national income of approximately:

• A. $100 billion — government spending has a multiplier of exactly 1 in the Keynesian model
• B. $300 billion — using the spending multiplier formula MPC/(1 − MPC) = 0.75/0.25 = 3
• C. $400 billion — the spending multiplier is 1/(1 − MPC) = 1/(0.25) = 4
• D. $75 billion — the aggregate effect equals the MPC multiplied by the initial injection

Answer: (C)

The Keynesian spending multiplier is 1/(1 − MPC). With MPC = 0.75, the multiplier is 1/0.25 = 4, giving $400 billion total. The logic: each dollar of government spending becomes income for someone, who spends 75 cents, generating 75 cents of new income for others, who spend 75% of that, and so on. The geometric series sums to 1/(1 − 0.75) = 4. Option B uses MPC/(1 − MPC), a plausible but incorrect formula. The real-world multiplier is typically smaller than 4 due to taxes, imports, and crowding out, but 1/(1 − MPC) is the textbook formula.

Question 3

According to the permanent income hypothesis, a household receiving a permanent raise of $10,000 per year will increase its annual consumption by more than a household receiving a one-time bonus of $10,000.

• T. True
• F. False

Answer: True

The permanent income hypothesis predicts that consumption responds to changes in permanent income. A $10,000 permanent raise increases permanent income by $10,000 per year, generating a large, sustained consumption increase of approximately MPC × $10,000 annually. A one-time $10,000 bonus increases permanent income by only a small amount — the bonus spread over remaining life expectancy — generating a much smaller annual consumption increase. This is the core PIH prediction: temporary income changes produce muted consumption responses; only permanent shifts substantially move the consumption function.

Question 4

The fiscal multiplier in a real economy equals exactly 1/(1 − MPC) because most additional income generated by government spending cycles back into domestic consumption.

• T. True
• F. False

Answer: False

The textbook formula 1/(1 − MPC) assumes all additional income is spent on domestic consumption goods. In practice, the effective multiplier is smaller for three reasons: (1) taxes leak income before it reaches consumers, reducing the effective MPC; (2) imports divert spending to foreign producers, removing it from the domestic multiplier cycle; (3) higher government borrowing can crowd out private investment by raising interest rates. Real-world fiscal multiplier estimates typically range between 0.5 and 2.5, well below what the simple formula implies for high MPC values.

Question 5

Explain why a permanent tax cut is predicted to have a larger effect on consumer spending than a one-time tax rebate of the same annual dollar amount, and what this implies for fiscal policy design.

Model answer: The permanent income hypothesis says consumption is driven by permanent income — what a household expects to earn over its lifetime. A one-time rebate barely moves permanent income (its annuity value spread over a lifetime is small), so households save most of it. A permanent tax cut raises expected income in every future period, substantially increasing permanent income and generating a large, sustained consumption response. For fiscal policy, this means one-time stimulus payments have weaker demand effects per dollar than permanent changes. To maximize stimulus effectiveness, policymakers should either make income increases permanent or target them to liquidity-constrained households, who consume out of current income regardless of whether it is permanent.

Liquidity-constrained households — those who cannot borrow against future income — consume out of current income even when they know it is temporary, raising the aggregate MPC above pure PIH predictions. This is why targeting transfers to cash-poor households is a standard recommendation for maximizing stimulus effectiveness: for them, the distinction between temporary and permanent income matters less.