Exploring Consumption

1. Although the life-cycle and permanent-income hypotheses were both developed in the 1950s, not until the presidency of Lyndon Johnson did most economists fully realize the importance of the idea that people could smooth out fluctuations in income. In 1967 the Johnson administration proposed a tax increase to curb rising inflation. The proposed tax was unusual because it was a temporary tax, designed to last only one year, and because it was a surcharge, a 10% tax on the taxes a person owed. The proposed tax was temporary because the Johnson administration saw the problem of inflation as temporary. Proposing the increase as a surcharge rather than a change in the tax rates was a way to speed passage without having Congress attach a variety of changes in the tax laws. The surcharge was enacted in June of 1968 and expired in mid 1969.

a) What did the traditional consumption function predict would happen to consumption as a result of the surcharge? To savings? To the ratio of savings to consumption?

b) What did the permanent-income hypothesis predict would happen to consumption as a result of the tax? To savings? To the ratio of savings to consumption?

c) Below are data showing the ratio of personal savings to personal outlays. Quarterly data are given for years with a Roman numeral. Do the savings ratios tend to support the prediction of the traditional consumption function or of the permanent-income hypothesis?



1968 IV
1969 I
1969 II
1968 I
1969 III
1968 II
1969 IV
1968 III

Source: 1971 Business Statistics (Biennial Supplement to The Survey of Current Business), Dept. of Commerce, Bureau of Economic Analysis

In the Two-Income Trap: Why Middle Class Mothers and Fathers Are Going Broke (Basic Books, 2003) authors Elizabeth Warren and Amelia Warren Tyagi found that households in which both spouses work are more likely to file for bankruptcy than households in which one spouse stays at home. This finding may sound counter-intuitive, and it surprised the authors. However, consumption theory may help explain why it is so. (Editorial comment: The authors know a lot about law but do not seem to have much background in economics. Their book would have been much more persuasive if they had used more economics.)

a. Suppose that we have two identical families, the Smiths and the Jones. Both Mr and Mrs Smith work and they earn $70,000. Only Mr Jones works and he earns $40,000. Should we expect the Smiths to save a greater percentage of their income than the Jones? Who will have the higher standard of living?
b. If Mr Smith and Mr Jones both lose their jobs, one option is to cut spending and reduce standard of living. Should this be easy for either? Should it be easier for Jones or Smith? Why? If we stop here, does the conclusion of The Two-Income Trap seem reasonable?
c. When a person loses a job, the household suffers a disruption of income. Suppose all workers have a 10% chance of suffering a loss of job. Which household is more likely to suffer a disruption of income during any year? Does this support or contradict the finding of The Two-Income Trap?
d. When a household suffers a disruption of income, one possible response is to cut standard of living. However, the family with only the husband working has another option that the two-income family does not have. What is it? Does this option make the finding of the book more plausible?

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