Exercise
Set 11
THE CONSUMPTION FUNCTION
I. Objectives
- To sketch the consumption
function.
- To understand the Marginal
Propensity to Consume (MPC).
- 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
To answer Questions 1-6, assume a
= 800, b
= 0.6, T
= 90.
- Why do we select a value for b
that lies between 0 and 1?
- The marginal propensity
to consume (MPC) is _______.
- This implies that if
disposable
income
rises
by $200, ceteris paribus,
consumption will [ rise | fall
] by $
_______. Explain.
- Sketch the consumption
function (with Y
on the horizontal axis). The vertical intercept is
_________ and the slope is ________.
- The marginal propensity
to
save (MPS) is _______.
- This implies that if
disposable income rises by
$200, ceteris
paribus, saving will [ rise |
fall
] by $ _______.
Explain.
- Sketch the saving
function
(with Y
on the horizontal axis). The vertical intercept is __________
and the slope is ________.
- Suppose the parameter a
increases. This will cause the consumption function to shift [ up |
down ]. Using a new value of a,
confirm your result.
- In each case below,
explain
whether the consumption function will shift up or down, and why.
- The stock market
falls.
[Note: This shows the wealth
effect.]
- The Federal Reserve
cuts
interest rates.
- The govt. provides
an
income tax cut.
- Provide an example of
fixed-income securities held by households.
- What is the "fixed income"
generated by the asset?
- Can we consider cash to be a fixed-income asset?
- 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.]
- Suppose taxes were endogenous,
i.e., they varied with income. An example of such a tax function is:
T = 0.25Y.
- In the consumption
function, let a
= 800, b
= 0.6. So we have C
= 800 + 0.6(Y-T).
- Use the given tax
function T
= 0.25Y to obtain disposable
income in terms of income: DI
= ______________________.
- Obtain the
consumption
function (in terms of Y):
C
= ______________________.
- Sketch C
vs. Y.
- The
slope of the line is __________.
- Note that the
slope no longer equals MPC. Why?
Video:
Solution to Section III
Questions at
http://www.screencast.com/t/OXjdwDObDpfm