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Is consumption more or less volatile than income

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Is consumption more or less volatile than income? What theory explains this fact?  Consumption is less volatile than income and according to Milton friedman permanent income hypothesis theory of estimates that people will actually spend more dollars equal to that of the long-term average income where the consumption patterns remain less volatile for this reason but income might change with the coming time where there can be hike ro no hike etc and therefore permanent income hypothesis explains the scenario

What determines the opportunity cost of forgoing consumption today in order to increase consumption in the future.

The opportunity cost is the difference between the expected returns of each option.If the difference between expected return from forgoing consumption today and consumption in future is positive then we should forgo the present consumption in order to increase the consumption in future. Thus, if today we forgo our consumption and consume it in the future our expected return should be more which determines the opportunity cost.

Why is the assumption that consumers can borrow (or save) as much as they want important for the Permanent Income Hypothesis?

The Permanent Income Hypothesis argues that people consume based off of their overall estimation of future income. Economic thought at the time assumed people consumed only based on their current after-tax income.

If credit is limited, can consumers perfectly smooth consumption? Why or why not?

in this way, she “smooths” her consumption, consuming only slightly less during college than immediately after. This is even after the huge increase in income.

Is consumption more or less volatile than income

How do expectations of future income play a role in the PIH?

 

What are the two channels through which an increase in the real interest rate affects consumption decisions? Can we tell which channel has a larger impact in theory? In practice, which channel has a larger impact? An increase in real interest rate decreases consumption levels in an economy. A higher real inerest rate has two specific effects: a) Saving levels in the economy experience a positive substitution effect as higher levels of saving are rewarded by a higher level of return in the form of higher interest. b) Saving levels in the economy experience a mixed income effect when real interest rate rises.

  1. I) it is negative for target savers (i.e. net savers) as they require lesser savings to reach the targeted corpus at the end of the saving period.
  2. II) it is positive for net borrowers as increase in real interest rate signifies loss of net wealth.

Therefore, an increase in real interest rate actually encourages higher saving and lesser borrowing thus decreasing levels of consumption in the economy.

Suppose you become pessimistic about your future income. What does this do to the consumption demand curve?

If consumers become more pessimistic about future income, this will likely decrease their current consumption. As a result, Consumption demand curve will shift to the left.

 

Suppose your income in year 1 is $1,000 and in year 2 it increases to $1,100. If you choose your income following the PIH how much should you consume in each year?

PIH assumes people tend to smoothen their consumption levels through periods of uneven incomes. People tend to relate their consumption with what they assume to be their “normal” income which could be an average of past incomes or an average of future income streams. Hence, an autonomous investment in a particular period and consequent increase in income in that period might not have a steady multiplier effect.

Suppose your income in question 8 rises by $100 per year. How much should your consumption rise in each year?  Since the increase in income is taking place each year, thus, the increase in income is permanent. Permanent increase in income will increase the consumption level in the economy and consumption will increase by Marginal Propensity to consume times the disposable income of the consumer. Permanent increase in income will lead to rise in the consumption level of the consumer.

Suppose your income from question 8 increases by $100 only in year 1. How does this affect your consumption choice in each year?  Since the increase in income is only transitory and not permanent and thus increase on income level in year 1 only will not have much impact on consumption level of the economy as per Permanent Income Hypothesis. It might lead to slight increase in period 1 but no increase in consumption level in other periods.Is consumption more or less volatile than income

Chapter 6

What must be true for Gross Investment to be equal to Net Investment? If the amount of Depreciation will be equal to 0, the gross investment will be equal to net investment

If an economy has positive Gross Investment can we conclude that the economy is in good economic shape? Yes, if the amount of gross investment is positive, it is a good sign for the economy. It shows that the investments are productive and also shows the faith of the investors on the economy. Thus, it is definately a good indicator. If this amount is negative or zero, signifies the lack of faith as is not good for the economy

Provide some examples of both tangible and intangible investment. Tangible assets are physical; they include cash, inventory, vehicles, equipment, buildings and investments. Intangible assets do not exist in physical form and include things like accounts receivable, pre-paid expenses, and patents and goodwill.

Using the firms profit maximization problem, explain what happens to the desired capital stock in the second period if interest rates rise. How does this change impact the investment demand curve?  A change in the interest rate will affect a firm investment decision inversely. If there is an increase in the interest rate or in other words, there will be an increase in the cost of borrowing from the banks and therefore which encourages firms to invest less. A decrease in investment spending means that in the second period of production the firm will plan a lower capital stock as compared to that it has in the previous period due to lower investment decision.

The investment demand curve represents the quantity of investment in an economy at different interest rates with other things remaining constant. It is a downward sloping curve with investment on the x-axis and interest rates on the y -axis. Due to a rise in interest rates, as mentioned above, the investment will fall, leading to an upward movement along the investment demand curve.

Is consumption more or less volatile than income

Using the firms profit maximization problem and the investment demand curve explain what happens after a decrease in productivity. A decrease demand means that people wish to purchase less of this good at every price than before. There are smaller quantities demanded at all possible prices. The demand curve shifts down to the left. A decrease in demand results in a fall in the equilibrium price and a fall in the equilibrium quantity.

 

If the interest rate changes, do we shift the investment demand curve or move along the curve. Explain why

Investment demand curve depicts the negative relationship between interest rate and level of investment.  On Y-axis, interest rate is plotted. On X-axis, investment level is plotted. When the interest rate changes, we move along the curve. It is because whenever there is change in the Y-axis variable we move along the curve. If there are changes in other than variables plotted on Y-axis, we shift the curve.

How can a natural disaster increase period 1 GDP (right after the disaster occurs) but decrease period 2 GDP (long after the disaster) What assumption are we making about capital stock? That is, are firms replacing capital after the disaster? Right after the natural disaster, which has resulted in destruction / erosion of capital stock, firms and governments would focus on re-building capital stock. This would result in GDP going up as Investment is a part of GDP. In the next period (period 2), however, there won’t be any more extraordinary investment (assuming all of the investment required for re-building was done in period 1 itself), so GDP won’t get a lift because of investment. There may, on the other hand, be some sustained loss of productivity due to loss of lives (manpower) during the disaster which cannot be made up in the short run. So, the GDP would decrease in period 2, as compared to period 1 (or even as compared to period 0).

Show what happens to the investment demand curve if there is an increase in depreciation. Provide economic intuition for your result. As the result of the increase in the depreciation, the investment will shift rightward. This is because, when the rate of the depreciation will increase, more amount of the investment will be needed to meet up the growing technology because increasing depreciation will mean that the current technology is getting outdated with speed. Hence the investment will be needed to be increased

 

Chapter 7

After an increase in the wage rate do consumers want to work more or less? Hint: it’s a trick question! Consider both theory and empirical evidence.

As per the theories given, when the wage rate increases, the substitution effect comes into action and the work time is substitutes by more leisure time. This means that when the wage rate rises as a result of increased earning, the workers tend to involve more in the leisure activities. However, the workers due to the rise in their wage rates, try to work more harder with the aim of maximizing their earning more and more.

Explain why an upward sloping labor supply curve requires that substitution effects are greater than income effects with respect to changes in wages. If the income effect dominates, what is the slope of the labor supply curve? Labor supply curve denotes the relationship between wages of the labor and the hours of work they do.Is consumption more or less volatile than income

Substitution effect in context of labour supply refers to the substation of leisure time with the hours of work when the wages increase and vice-versa.

Income effect on the other hand refers to the increased real income when the wages rise. Income effect is negative in labour supply and substitution effect is positive in labor supply. If income effect dominates, then the curve of labor supply would be downward sloping. Or we can say that, the curve Will show negative relationship between wages and hours worked.

Is it important to assume that leisure is a Normal good? Explain why or why not?

Leisure is generally assumed to be a normal good. … Your demand for leisure increases, suggesting you will work less (income effect). The price of leisure, however, increases (since you’re higher paid, each foregone hour is more expensive), suggesting you will work more (substitution effect)

If leisure is an inferior good, what is the slope of the labor supply curve?

If leisure is an inferior good then labor supply curve will be upward sloping because when wage rate increases, substitution effect will make a labor to decrease its leisure and increase its labor because opportunity cost has decreased. Whereas increase in wage rate has made consumer income to increase and makes consumer to have more leisure.

Explain how the optimal combination of work and consumption changes after a decline in the wage rate. (It would be helpful for you to practice graphing this in the consumer’s problem)  when the wage of the labor decrease or increase, its widely effect the consumption as well as work of labor, because When income decrease the consumer will shift the preference of food like earlier, he eat normal good, after decreasing income he eats inferior good, vice versa.  When income decline to then it will find the new work for stable the earning so that he lives the life as before he lives when income can’t decline. Or he decreases the expenses. The wage or income effect expresses the impact of changes in purchasing power on consumption, while the substitution effect describes how a change in relative prices can change the pattern of consumption of related goods that can substitute for one another. The optimal condition is when, he have a stable job so that his earning is stable, and consumption is according to hi earning.

Suppose that consumers pay tax on their wage income. Explain how this affects the labor supply curve. This would be another one that would be helpful to graph.  It can be mentioned that consumers get to pay tax on their wage income as a result of which it can be mentioned that it would be de motivating factor for or people to join the labor due to the tax as a result of which the supply of labor decreases with which the supply curve shift to the left because of the decrease in the net wage. Is consumption more or less volatile than income

If part of a firm capital stock is wiped out, perhaps from a natural disaster, what happens to the profit maximizing amount of labor demanded? Use the firm’s output decision to confirm this.

The profit maximization level of labor is decided where W=MRP

MRP= MPP times MR

The fall in the capital availability would decrease the MPP of labor, MRP falls, so the demand of labor as well

  1. Following on from question 6, trace out the equilibrium effects of the loss of capital on the labor market equilibrium level of wages and labor.

What happens to the equilibrium level of labor after a decline in the level of technology? A decline in the level of technology implies that output is reduced for each unit of labor employed. This can also be seen as a reduction in the marginal product of labor which means that labour demand is affected. This discourages firms to continue hire the same number of units of labor, so they demand fewer labor units at every wage rate. This is likely to decrease the demand for labor and the demand curve of labor to shift to the left. As a result, there will be a decline in the market wage rate and reduction in equilibrium level of labor.

Suppose the cost of renting capital increases (r). What happens to the amount of labor the firm chooses to maximize profits?  If the cost of renting capital increases, the total cost of producing output increases. The firm might choose to replace capital with labors if they are comparatively cheaper. This will lead to a rise in amount of labor the firm chooses to maximize profits.

Continuing on from 9 what is the effect of this change on the equilibrium level of wages and hours worked?

Chapter 8

How would a decrease in consumption demand impact the aggregate demand curve? Similarly, how would a decrease in investment demand impact the aggregate demand curve? Aggregate demand is sum total of consumption and investment hence both consumption as well as investment are positively related with aggregate demand. For example consumption is 250 and investment is 100 in that case aggregate demand will be AD = C+I (250+100) 350, if the value of consumption decreases then value of aggregate demand will decrease, in above example if consumption decreases from 250 to 200 then value of aggregate demand will be (200+100) 300, also if value of investment decreases then overall value of aggregate demand will decrease in above example if value of investment decreases from 100 to 80 then value if aggregate demand will be (250+80) 330. From above analysis it can be said that consumption and investment both are positively linked with demand.

 

  1. Explain the impact of a change in labor supply on the aggregate supply curve.

If labor supply decreases, what is the impact on the AD/AS equilibrium?

It can actually be mentioned that if the labor supply increases then the supply increases as a result of a scholarship to the right and the equilibrium quantity increases and equilibrium price level decreases as shown in the figure.

Gross Investment is the total amount of investment undertaken in the economy

Net Investment is equal to gross investment less the amount of capital that has depreciated.

Depreciated capital is the capital that is used up or worn out in the production process

Tangible investment is investment in capital goods that we can see and easily quantify.

Input to Production is anything, such as capital, used to produce output via the production function

Diminishing Marginal Product of Capital is the property that each additional unit of capital used in production yields a smaller amount of output than the unit before

The capital accumulation equation is:  K2=(1-d)K1+I1

The Investment Demand curve is a downward sloping curve that relates the interest rate at which firms borrow to the quantity of investment they undertake.

Tobin’s Q is the ratio of the value of the stock market to the replacement cost of capital. The equation form Tobin’s q is q= valIs consumption more or less volatile than income