According to the life cycle theory of consumption, individuals make consumption decisions based on their lifetime income expectations and their desire to smooth consumption over their lifetime.
Annual consumption given the initial information: C = $0 - Annual consumption with increased permanent income: C = $520,000 - Marginal Propensity to Consume out of Permanent Income (MPCYP): MPCYP = 1 (or 100%) - Increase in annual consumption with a one-time income increase: Annual consumption increase = $10,000 - Marginal Propensity to Consume out of Transitory Income (MPCYT): MPCYT = 1 (or 100%) According to the life cycle theory of consumption, individuals make consumption decisions based on their lifetime income expectations and their desire to smooth consumption over their lifetime. The theory suggests that individuals aim to maintain a stable standard of living and adjust their consumption patterns based on changes in their income.
Given the information provided:
1. Annual Consumption:
To determine the annual consumption, we can use the concept of lifetime income. Lifetime income is the present value of all future income streams, taking into account the duration of the working period and expected lifespan.
In this case, working from age 22 to age 70, the duration of the working period is 70 - 22 = 48 years.
Using the formula for present value, we can calculate the lifetime income:
Lifetime income = Annual income * (1 - (1 + interest rate) ^ -years) / interest rate
Assuming an interest rate of 0 (for simplicity), the calculation would be as follows:
Lifetime income = $40,000 * (1 - (1 + 0) ^ -48) / 0
Lifetime income = $40,000 * (1 - 1) / 0
Lifetime income = $0 (since interest rate is 0)
Since lifetime income is zero in this case, annual consumption would also be zero.
2. Increased Permanent Income:
If your yearly income increases by $10,000 per year permanently, we can recalculate the annual consumption based on the new income.
New annual income = $40,000 + ($10,000 * (70 - 22))
New annual income = $40,000 + ($10,000 * 48)
New annual income = $40,000 + $480,000
New annual income = $520,000
The annual consumption would be equal to the new annual income:
C = $520,000
3. Marginal Propensity to Consume out of Permanent Income (MPCYP):
MPCYP measures the proportion of additional permanent income that is consumed. In this case, since the increase in income is permanent, the entire increase is consumed.
MPCYP = 1 (or 100%)
4. One-time Increase in Income:
If you receive a one-time only increase in your income of $10,000, the additional amount would be consumed but not spread over multiple years.
Annual consumption increase = $10,000
5. Marginal Propensity to Consume out of Transitory Income (MPCYT):
MPCYT measures the proportion of additional transitory income that is consumed. In this case, since the income increase is one-time and not expected to continue, the entire increase is consumed.
MPCYT = 1 (or 100%)