Questions: Consumption Smoothing and Permanent Income Hypothesis

Question 1

A government announces a one-time $1,200 stimulus check for every household. Under the permanent income hypothesis, what effect should this have on household consumption spending?

• A. Consumption rises by approximately $1,200, since households spend windfalls immediately
• B. Consumption rises by a small fraction of $1,200, since the household recognizes this as a transitory income gain and saves most of it
• C. Consumption is unchanged, since the PIH predicts zero response to any income changes
• D. Consumption rises by more than $1,200 due to the Keynesian multiplier effect

Answer: (B)

A one-time check is a transitory income shock — it raises income in one period but doesn't change the household's permanent income (the annuity value of lifetime resources) by much. A forward-looking consumer spreads this windfall over their remaining lifetime: if they have 40 years left, they might spend roughly $30/year — a small fraction of $1,200. Option A represents the naive Keynesian view (MPC ≈ 1). Option C overstates the PIH; permanent income does change slightly, but very little.

Question 2

A young engineer earns $70,000/year but expects substantial raises and expects to earn $200,000/year within 10 years. Under the permanent income hypothesis, compared to a coworker with identical current income and no expected raises, this engineer will...

• A. Consume the same amount, since the PIH bases consumption on current income
• B. Consume less, to save for the uncertainty of future income
• C. Consume more, since their permanent income exceeds their current income — potentially by borrowing
• D. Consume more only if interest rates are low enough to make borrowing worthwhile

Answer: (C)

Under the PIH, the engineer's consumption is based on permanent income — the annuity equivalent of their entire lifetime earnings — which is much higher than $70,000/year given expected career trajectory. Since permanent income exceeds current income, the PIH predicts they will borrow against future income and consume more than $70,000 today. The coworker with flat income has a permanent income close to $70,000 and consumes accordingly. Current income is irrelevant except as a signal about permanent income.

Question 3

Under the permanent income hypothesis, a temporary income shock — such as an unexpected one-year bonus — should cause almost no change in consumption.

• T. True
• F. False

Answer: True

A temporary shock affects only one period's income. When spread over a lifetime of, say, 40 remaining years, the impact on permanent income is roughly 1/40 of the shock. Since consumption tracks permanent income, the marginal propensity to consume out of transitory income is very close to zero. Almost all of the temporary windfall should be saved. This is the sharpest empirical prediction of the PIH and one of its most tested implications.

Question 4

The permanent income hypothesis implies that households with higher current incomes generally consume more than households with lower current incomes.

• T. True
• F. False

Answer: False

The PIH says consumption tracks permanent income, not current income. A young doctor in residency (high permanent income, low current income) may consume more than a retired worker on a comfortable pension (moderate permanent income, moderate current income). Conversely, a farmer who had a one-time bumper crop has high current income but low permanent income and should save most of it, consuming little. Current income is only relevant insofar as it updates the estimate of permanent income.

Question 5

Why does the permanent income hypothesis predict a low marginal propensity to consume out of a transitory tax rebate, and what does this imply for the effectiveness of temporary fiscal stimulus?

Model answer: A transitory rebate raises income in only one period. A rational forward-looking household distributes the benefit over its remaining lifetime, spending only 1/T of the windfall per year (where T is remaining years). The MPC out of transitory income is therefore approximately 1/T, which is close to zero for households with many years ahead. This implies temporary fiscal stimulus has limited effect on consumption: most of the rebate gets saved rather than spent. Permanent tax cuts, which raise permanent income by the full annual amount, would have a much larger consumption effect.

This distinction is central to fiscal policy debates. Proponents of stimulus checks argue that liquidity-constrained households (those who can't borrow against future income) may have MPC near 1 even for transitory income — a real-world deviation from the PIH. The PIH provides the benchmark; the gap between the benchmark and empirical MPCs reveals the fraction of households facing binding credit constraints.