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1. Assuming the real interest rate is 4%, calculate how, according to the PIH, consumption and borrowing would change in each of the following cases (a) A stock market crash permanently reduces the value of an individual's assets by 1,000. (b) Households are told that in a year's time, they will receive a one-off bonus of 1,000. Then in one year's time, it is not paid. (c) Comment briefly on your results.
2.The opportunity cost of shifting production choices The following graph shows the production possibilities curve (PPC) of an economy that produces clothing and steel. The black points (plus symbols) represent three possible output levels in a given month. You can click on the points to see their exact coordinates. ? 40 35 PPC 30 25 CLOTHING (Thousands of pieces) 20 15 10 5 0 0 90 180 630 720 270 380 450 540 STEEL (Millions of tons)
Suppose the economy initially produces 15,000 pieces of clothing and 450 million tons of steel, which is represented by point A. The opportunity cost of producing an additional 5,000 pieces of clothing (that is, moving production to point B) is____ tons of steel. (A. 54 million, B. 72 Million, C. 90 Million, D. 108 Million. E. 135 Million)
Suppose, instead, that the economy currently produces 378 million tons of steel and 20,000 pieces of clothing, which is represented by point B. Now the opportunity cost of producing an additional 5,000 pieces of clothing (that is, moving to point C) is ___ tons of steel. (A. 54 Million B. 72 Million C. 90 million E. 108 Million E.135 Million)
Comparing your answers in the two previous paragraphs, you can see that the opportunity cost of 5,000 additional pieces of clothing at point B is _____ the opportunity cost of 5,000 additional pieces of clothing at point A. (A.greater than B. Less than C. Equal to)
This reflects the _______ (A.Law of increasing opportunity costs B. fact that resources are scarce C. notion that countries can gain from trade.)
3.Explain the concepts of excess sensitivity and excess smoothness that arise from the empirical literature on the permanent income hypothesis. What could explain these findings?
1. When the assets are decreased by 1000, the impact on lifetime wealth will be a reduction of by [(1 + r) * 1000]. Consumption will reduce by 1000 - [(1 + r) * 1000] = 1000 - 1.04 * 1000 = $40. There will be no change in borrowing.
2) When the bonus is announced, it will cause an increase in lifetime wealth by the discounted value of the bonus: (1/1+r) 1000. Thus it will result to an increase in consumption immediately by [(r/1+r)(1/1+r )*1000] = [(0.04 / (1 +0.04) * 1 / (1 + 0.04) * 1000] = [0.03846 * 0.96154 * 1000] = 36.98.
Households have to borrow this amount for financing the consumption, because bonus has already been announced and have to be arrived in a year's time. When the bonus would not arrive, the assets of household's will be lowered permanently with the amount borrowed. Their lifetime wealth would be reduced by: [1+r] 36.98 = 1.04 *36.98 = 38.46. Thus it will cause a reduction in consumption from the initial level with amount of interest.
3) Under the PIH, the consumption will be smooth by the households over the lifetime. The freely borrowing will be a critical assumption.
2.The opportunity cost of producing additional 5,000 pieces of clothing is 72 million tons of steel (450 million-378 million=72 millions, moving to point B).
Ans-2 108 million.
The opportunity cost of producing an additional 5,000 pieces of clothing is 108 million tons of steel.( 378 million- 270 million=108 million, moving to point C).
Ans-3 The opportunity cost of 5,000 additional pieces of clothing at point B is less than the opportunity cost of 5,000 additional pieces of clothing at point A.
Ans-4 law of increasing opportunity cost- the law of increasing costs is a principle that states that once all factors of production (land, labor, capital) are at maximum output and efficiency, producing more will cost more than average. As production increases, the opportunity cost will increase as well.
3.
Excess sensitivity refers to that the consumption which reacts more than the change in Income as indicated by the Permanent Income Hypothesis. For example: fall in income at retirement. According to the Permanent Income Hypothesis theory, Consumption falls upon news and does not react when the actual retirement happens. However, according to data when income falls, consumption also falls. We can also analyse the situation by comparing consumption while being at work and spending leisure time at home after retirement. Hence, production at home might substitute consumption spending.
Excess smoothness is attributed to failures in theoretical predictions: the presence of credit constraints prevent from borrowing who lack collateral wealth, impatience in savings as predicted by permanent income view and uncertainty of future leading precautionary saving over and above the level as predicted by PIH.
