Question

According to the permanent income hypothesis, if a person received a windfall of \(\$ 100,000\), he would spend that year. (LO7) a) some of it c) nearly all of it b) most of it d) all of it

Short answer

According to the Permanent Income Hypothesis, if a person received a windfall of $100,000, he would spend \(a) \text{ some of it}\), as this option considers the long-term aspect of income and spending.

Step-by-step solution

Option a) Some of it

If the person spends only some of the windfall, that means they are spreading out their spending over a longer period, considering their long-term income expectations. This option appears to be in line with the Permanent Income Hypothesis.

Option b) Most of it

If the person spends most of it, they are still considering their long-term income but may be allocating a larger portion to their current expenses. This option is also somewhat in line with the Permanent Income Hypothesis, but less so than option a).

Option c) Nearly all of it

If the person spends nearly all of it, they are mostly focused on their current expenses and not considering their long-term income as much. This option seems less likely to follow the Permanent Income Hypothesis.

Option d) All of it

If the person spends all of it, they are only considering their present expenses and not spreading out the extra income over time. This option does not align with the Permanent Income Hypothesis, as it focuses too much on current consumption. According to our analysis, option a) some of it best aligns with the Permanent Income Hypothesis, as it considers the long-term aspect of income and spending.

Key concepts

Economic Behavior

Understanding the way individuals make financial decisions, particularly regarding spending and saving, is a key dimension of economic behavior. The Permanent Income Hypothesis (PIH) posits that people base their consumption not just on their current income, but more significantly on their expected long-term average income.

According to this theory, individuals aim to maintain a stable consumption level over time, even if their income fluctuates in the short term. Therefore, when they receive a windfall, as in the exercise, the rational behavior would be to spread this extra income over time to stabilize consumption over longer periods, rather than spending it all at once. This is due to the fact that a windfall is a one-time event, not representative of a consistent increase in income.

Consumption Patterns

Consumption patterns describe how people spend their money, on what they spend it, and how this spending varies over time. According to the PIH, consumption patterns are more closely related to an individual's perceived longer-term earnings rather than immediate variations in income.

When there's an unexpected gain, such as a $100,000 windfall, a person might splurge in the short term; however, the PIH suggests that a rational consumer would not significantly alter their ongoing consumption pattern. Instead, they would save or invest part of that windfall, considering future periods as well, which could lead to a moderate increase in consumption consistent with the increase in permanent income.

Windfall Spending

Windfall spending refers to how consumers allocate unexpected, non-recurring influxes of cash. Individuals might be tempted to immediately spend a significant portion of a windfall, but the PIH suggests a different approach.

According to this hypothesis, a prudent person would view such windfalls as an addition to their asset base rather than an increase in their regular income. Hence, they would only spend a fraction of this windfall, reflecting the portion of the windfall that they consider to be an increment to their permanent income, and save the rest for future consumption. This provides insight into why the 'some of it' option is most in line with the PIH, as it embodies the idea of spreading the gains over an extended period to smooth consumption.

Long-term Income Expectations

Long-term income expectations involve how individuals anticipate their income changing over the course of their lives. People tend to plan their spending and savings based on what they reasonably expect they will earn in the future, not just on their current earnings.

The windfall is thus treated as a component of the permanent income, which loosely equates to the average income one expects to maintain over time. Consequently, if individuals believe this windfall does not significantly change their lifetime income expectation, they will save most of it. They will not drastically alter their consumption habits, because their long-term income expectations remain unchanged. This underlines the notion that effective financial planning is deeply rooted in the foresight of long-term economic stability rather than immediate circumstances.