Exercise Set 9
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.

III. Questions

1. Select values for a, b and T.
   a = _________     b = _________     T = _________

2. Why must b lie between 0 and 1?

3. The Marginal Propensity to Consume (MPC) is _______. This implies that if disposable income rises by $200, ceteris paribus, consumption will [ rise / fall ] by $ _______. Explain.

4. Sketch the consumption function (with Y on the horizontal axis). The vertical intercept is _________ and the slope is ________.

5. The Marginal Propensity to Save (MPS) is _______. This implies that if disposable income rises by $200, ceteris paribus, saving will [ rise / fall ] by $ _______. Explain.

6. Sketch the saving function (with Y on the horizontal axis). The vertical intercept is __________ and the slope is ________.

7. Suppose the parameter a increases. This will cause the consumption function to shift [ up / down ]. Using a new value of a, confirm your result.

8. 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.

9. Provide examples of fixed income securities held by households. What is the "fixed income" generated by these assets?

10. According to the real balance effect, an increase in the price level will cause the real value of fixed income assets to [ rise / fall ] leading to [ an increase / a decrease ] in household wealth and thus [ an increase / a decrease ] in consumption.

11. Suppose taxes were endogenous, i.e., they varied with income. An example of such a tax function is:
    T = 0.25Y.
    1. Select values for a and b:     a = _______     b = ________.

    2. Use the given tax function to obtain disposable income in terms of Y:

       DI = ______________________.

    3. Obtain the consumption function (in terms of Y):     C = ______________________.

    4. Sketch C vs. Y. The slope of the line is __________. Is the slope equal to MPC? Explain.