Macroeconomics 1102

Macroeconomics 1102

Discussion Question 5

Part (a)

Consumption function: is the relation of consumption with its determinants.

Graphically drawn as:.

Mathematically it is written as:

C = C + c(Y – T)

C: Consumption Spending

C: Exogenous Consumption

c : Marginal Propensity to Consume (0 < c < 1)

Y: Aggregate Income

T: Taxes

Explaining the main components:

Exogenous consumption: factors other than disposable income that affect consumption. So when consumers feel optimistic about their future, they will generally spend more and save less at any given level of disposable income. Reversely if consumers feel pessimistic about their future then the opposite will occur, where they will spend less and save more at all level of disposable income. An example of where the exogenous consumption would increase would be in times of economic boom, where share prices rise and property prices increase. Consumers would feel wealthier and hence tend to spend more rather than save, therefore increasing exogenous consumption. In times of economic recession however, consumers would feel poorer and uncertain, so they would save more and spend less hence driving exogenous consumption down.

Marginal propensity to consume: is the how much consumption rises for every extra dollar of disposable income. The assumption for marginal propensity to consume is that when a consumer receives a dollar extra of disposable income, a part of the dollar will be spent and the rest is saved. This means consumption will increase, but less than the full extra dollar. This is why the marginal propensity to consume denoted by c will always be greater than 0 but less than 1.

Part (b)

Multiplier: is the short term used for the income-expenditure multiplier. The theory behind the multiplier is that when consumer spending increases or decreases, the actual fluctuation that affect exogenous consumption will be multiplied by the multiplier denoted by c. The reason for this nature is that when consumers spend more, sales of consumer goods will increase which in turn will increase the income of workers and owners of industries that produce consumer goods. They in turn will also increase their spending which will eventually increase the output and income of almost every other producer and industry in the economy. The reduction of consumer spending will also comply with the multiplier theory and the opposite effect would occur.

The multiplier will always be greater than 1, which means the actual fluctuations of exogenous consumption will be greater than the fluctuation of consumer spending which is where it’s derived from. The reason why the multiplier is always greater than 1 is because it is derived from the following formula. 1/(1-c). As discussed in part (a), we knew that c (marginal propensity to consume) must be a number between 0 and 1, the inverse as you can see will always be greater than 1.

Part (c)

Line graphs of real consumption expenditure against year for the four countries:

The graphs of Australia and USA shows a steady growth of real consumption over time, without any major fluctuations, but looking at Japan and Korea on the other hand they have something in common which is the dramatic decline of consumption expenditure approximately around