If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will increase when:
A) previously announced tax reductions are implemented.
B) they receive an anticipated raise.
C) they receive an unexpected inheritance.
D) they make the last payment on their automobile loan.

Question

Quizplus · Accepted Answer

According to the permanent-income hypothesis, consumers base their current consumption on their expected long-term average income. An unexpected inheritance increases their perceived wealth and thus their long-term income, leading to an increase in current consumption. Choices A, B, and D involve anticipated changes, which should already be factored into their consumption decisions according to the rational expectations theory.

If Consumers Have Rational Expectations and Follow the Permanent-Income Hypothesis