Lecture 9
THE CONSUMPTION FUNCTION

1. Assumptions in our models

• Depreciation = Indirect business taxes = 0
  GDP = National income

• Corporate profits taxes = payroll taxes = 0
  DI = GDP - Personal taxes (T)

2. Exogenous and Endogenous variables

• Does the model "explain" a particular variable?
• Exogenous variables are "given" (assumed to be fixed)

3. The Consumption Function

• C = a + b(DI)
• Relates (real) consumption spending to (real) disposable income
• Positive slope
• Marginal Propensity to Consume (MPC): 0 < b < 1

3.1 Shifts of the consumption function caused by:

• Changes in wealth
• Changes in the price level (P) - real balance effect
• Changes in expected future income
• Changes in taxes

3.2 Permanent vs. temporary tax cuts

• Role of expectations

4. The Saving Function

• S = DI - C
• Marginal Propensity to Save (MPS)
• Why is MPC + MPS = 1?