According to the permanent income hypothesis, households will tend to react to a temporary tax cut by?
A) assuming the new tax level will be permanent.
B) saving most of the additional disposable income.
C) increasing consumption sharply in response to the higher disposable income.
D) temporarily increasing their marginal propensity to consume.
http://en.wikipedia.org/wiki/Permanent_income_hypothesis
The permanent income hypothesis suggests that households have an expectation about their long-term income rather than reacting to temporary changes. To answer this question, let's analyze each option:
A) Assuming the new tax level will be permanent: According to the permanent income hypothesis, households do not assume that temporary changes are permanent. Therefore, this option is not consistent with the hypothesis.
B) Saving most of the additional disposable income: The permanent income hypothesis suggests that households tend to save a significant portion of any additional income, including temporary tax cuts. This is because they base their consumption decisions on their expected long-term income, not just temporary changes.
C) Increasing consumption sharply in response to the higher disposable income: The permanent income hypothesis contradicts this option. Households are believed to have a stable level of consumption that does not fluctuate significantly due to temporary changes in income.
D) Temporarily increasing their marginal propensity to consume: The marginal propensity to consume refers to the proportion of each additional dollar of income that is spent on consumption. According to the permanent income hypothesis, households should have a stable marginal propensity to consume, which is not influenced by temporary changes in income.
Therefore, based on the permanent income hypothesis, the most accurate answer to the question would be B) saving most of the additional disposable income.