Expectations Part 2

Question 1

Give the expenditure components of GDP.

Answer 1

C - Consumption - goods and services purchased by consimers
I - Investment - purchase of capital goods
G - Gov. Spending - purchase of goods and services by the state or local government
IM - purchase of foreign goods by domestic consumers
X - purchase of domestic goods by foreign consumers

Question 2

Describe the relation between consumption and disposable income.

Answer 2

When disposable income decreases, consumption is likely to decrease.

Question 3

How can consumers maintain consumption when disposable income decreases temporarily?

Answer 3

Through borrowing

Question 4

Describe the relation between consumption and real GDP.

Answer 4

• Tend to move together
• Consumption is less volatile/smoother

Question 5

What main factors are consumption dependent on?

Answer 5

• Current income
• Exp. future income
• Household wealth

Question 6

Summarise Friedman’s permanent income theory.

Answer 6

Permanent income emphasises that consumers always look beyond current income

Question 7

Summarise Modigliani’s life cycle theory.

Answer 7

Emphasises that consumer’s natural planning horizon is their entire lifetime.

Question 8

What is total wealth?

Answer 8

Human wealth + financial wealth + housing wealth.

Question 9

What is human wealth?

Answer 9

The present value of expected future labour income

Question 10

What is financial wealth?

Answer 10

Contents of bank accounts, savings accounts and value of bonds and stocks

Question 11

What is housing wealth?

Answer 11

Value of house - value of remaining mortgage debt

Question 12

How would a very foresighted consumer decide how much to consume?

Answer 12

• Calculate total wealth
• Decide to spend a proportion of total wealth each year throughout life, borrowing if if Ct > Yt and saving if Ct < Yt

Question 13

How do you compute human wealth?

Answer 13

Multiply initial income, proportion of income kept after tax and compound real income rises whilst working age

Question 14

Why would foresighted predictions be unrealistic?

Answer 14

• Individuals may not maintain constant consumption over their lifetimes
• Computations involved in planning for constant consumption may be too complicated
• Human wealth is based on forecasts, which may turn out to be less than expected
• Banks may be unwilling to extend much credit to young adults on exp. future earnings

Question 15

Describe liquidity constraints.

Answer 15

As consumers cannot get credit, this explains the sensitivity of consumption to current income