Exercise Set 11
THE CONSUMPTION FUNCTION

I. Objectives

1. To sketch the consumption function.
2. To understand the Marginal Propensity to Consume (MPC).
3. To derive the saving function, and obtain the Marginal Propensity to Save (MPS).

II. Data

• The Keynesian consumption function is given by C = a + b(DI), where C is real consumption and DI is real disposable income.
• Disposable income is Income less Taxes: DI = Y - T.
• Taxes are assumed to be exogenous.
• Select values for the parameters a and b. Choose a value for T.
• Obtain MPC and MPS. Click on Gimme MPC! to confirm your results.

a =

b =

T =

MPC =

MPS =

Consumption function:

Saving function:

III. Questions 

1. Why do we select a value for b that lies between 0 and 1?
2. The marginal propensity to consume (MPC) is _______. 
1. This implies that if disposable income rises by $200, ceteris paribus, consumption will [ rise | fall ] by $ _______. Explain.
3. Sketch the consumption function (with Y on the horizontal axis). The vertical intercept is _________ and the slope is ________.
4. The marginal propensity to save (MPS) is _______. 
1. This implies that if disposable income rises by $200, ceteris paribus, saving will [ rise | fall ] by $ _______. Explain.
5. Sketch the saving function (with Y on the horizontal axis). The vertical intercept is __________ and the slope is ________.
6. Suppose the parameter a increases. This will cause the consumption function to shift [ up | down ]. Using a new value of a, confirm your result.
7. In each case below, explain whether the consumption function will shift up or down, and why.
   1. The stock market falls. [Note: This shows the wealth effect.]
   2. The Federal Reserve cuts interest rates.
   3. The govt. provides an income tax cut.
8. Provide an example of fixed-income securities held by households.
1. What is the "fixed income" generated by the asset? 
2. Can we consider cash to be a fixed-income asset?
9. An increase in the price level, ceteris paribus, will cause the real value of households' fixed-income assets to fall. Why? What is the effect on household wealth and, thus, on consumption? [This result is known as the real-balance effect.]
10. Suppose taxes were endogenous, i.e., they varied with income. An example of such a tax function is: T = 0.25Y.
    1. In the consumption function, let a = 800, b = 0.6. So we have C = 800 + 0.6(Y-T).
    2. Use the given tax function T = 0.25Y to obtain disposable income in terms of income: DI = ______________________.
    3. Obtain the consumption function (in terms of Y):  C = ______________________.
    4. Sketch C vs. Y. 
    1. The slope of the line is __________. 
    2. Note that the slope no longer equals MPC. Why?