The government announces two fiscal policies: Policy A is a one-time $500 tax rebate; Policy B is a permanent $500/year tax cut. According to the permanent income hypothesis, which policy produces a larger increase in consumption in the year it takes effect?
APolicy A, because lump-sum payments are immediately available to spend
BThey produce identical consumption increases because the dollar amounts are the same
CPolicy B, because households recognize the permanent income increase and raise their consumption accordingly
DNeither policy affects consumption — only wage income enters the consumption function
The permanent income hypothesis holds that households smooth consumption over their lifetime, responding primarily to changes in *permanent* income, not transitory windfalls. A one-time rebate (Policy A) raises lifetime wealth by only $500; a permanent tax cut raises lifetime wealth by $500 × remaining years. Households save most of the one-time rebate and spread it across their lifetime, so its immediate consumption effect is small. The permanent cut raises perceived lifetime income substantially, inducing a much larger immediate consumption increase. This distinction has major policy implications: temporary fiscal stimulus is less powerful than models assuming the simple Keynesian MPC would predict.
Question 2 Multiple Choice
If the marginal propensity to consume is 0.75 and a household receives a $200 increase in disposable income, what is the change in consumption predicted by Keynes's simple consumption function?
A$200, because all additional income is eventually consumed
B$150, because MPC = 0.75 means 75 cents of each dollar is spent
C$266, because the multiplier effect amplifies the initial income increase
D$50, because MPS = 0.25 determines what is consumed above the autonomous level
In Keynes's consumption function C = a + b·Y_d, the MPC (b = 0.75) is applied directly to the income change: ΔC = MPC × ΔY = 0.75 × $200 = $150. The household saves the remaining $50 (MPS = 0.25). Note that option C confuses the household's consumption response with the economy-wide multiplier effect — the multiplier describes what happens to *aggregate income* after a spending injection circulates through the economy, which is a separate (though related) concept.
Question 3 True / False
A higher marginal propensity to consume implies a larger fiscal multiplier, because less income leaks out of the circular flow as savings at each round of spending.
TTrue
FFalse
Answer: True
The fiscal multiplier is 1/(1 − MPC) in the simplest Keynesian model. When MPC = 0.8, the multiplier is 1/0.2 = 5; when MPC = 0.6, it is 1/0.4 = 2.5. The intuition: each round of spending generates income, which generates further spending — but each round also 'leaks' some income as savings (MPS = 1 − MPC). A higher MPC means less leakage per round and more total spending generated. Conversely, the multiplier would be infinite if MPC = 1 (no savings), which is why MPC < 1 is essential to keeping the model finite.
Question 4 True / False
According to Keynes's simple consumption function C = a + b·Y_d, a household with zero disposable income will have zero consumption.
TTrue
FFalse
Answer: False
The constant term *a* is autonomous consumption — spending that occurs even at zero income, funded by dis-saving (drawing down assets) or borrowing. Keynes included this term precisely to capture the empirical reality that households do not reduce consumption to zero when income falls to zero. Even unemployed households consume basic necessities by spending savings or taking on debt. Setting Y_d = 0 gives C = a > 0, not C = 0. Only a function with no intercept (pure proportional consumption) would predict zero consumption at zero income.
Question 5 Short Answer
Why does the fiscal multiplier exceed 1, and what role does the MPC play in determining its magnitude?
Think about your answer, then reveal below.
Model answer: The multiplier exceeds 1 because an initial spending injection circulates through the economy in successive rounds. When the government spends $1, that $1 becomes income for its recipients, who spend MPC of it (say $0.80), which becomes income for a second group, who spend MPC × MPC = $0.64, and so on. The total addition to output is 1 + MPC + MPC² + ... = 1/(1 − MPC). The MPC determines both how much circulates in each round and how quickly the series converges: a higher MPC means larger subsequent rounds and a larger total multiplier. The gap (1 − MPC = MPS) is the 'leakage' that prevents infinite amplification — each round of income some fraction is saved rather than spent.
The multiplier logic is why consumption's stability matters to macroeconomists: because C is such a large share of GDP and because MPC determines the multiplier, small changes in household spending behavior have large aggregate effects. It also explains why the permanent income hypothesis refines multiplier predictions — if households save temporary income, actual MPC out of transitory shocks is lower than the average MPC, and the effective multiplier for one-time fiscal interventions is smaller than the simple formula predicts.