2. The consumption function Consider a country with the national income of $12 b

Question

2. The consumption function Consider a country with the national income of $12 billion, the amount of taxes paid by households of $4 billion, and household consumption of $6 billion. Suppose that the marginal propensity to consume (MPC) is 0.625. On the following graph, use the blue line (circle symbol) to plot the economy's consumption function Hint: You should plot the first point where household consumption equals $6 billion. Then, plot the second point when real disposable income rises by $4 billion Consumption Function 14 E12 O 10 0 24 8 0 12 4 8 20 REAL DISPOSABLE INCOME (Billions of dollars)

Explanation / Answer

Solution: We know, consumption function is: C = C(bar) + MPC(Y - T), Y = national income, T = taxes paid, C(bar)= autonomous consumption (i.e, consumption when income is 0)

We are given C= $6 billion, Y = $12 billion, T = $4 billion, MPC = 0.625. Disposable income, Yd = Y - T

Using this, 6 = C(bar) +0.625(12 - 4)

C(bar) = 6 - 0.625*8

C(bar) = 6 - 5 =1. So, autonomous spending = $1 billion.

Since, it is the amount of consumption when Yd = 0, it is our vertical intercept

So, our consumption function becomes: C = 1 + 0.625*Yd. As in the question, the plotting is correct with vertical intercept = $1 billion and slope = 0.625

Using the first equation, i.e, C = C(bar) + MPC*(Y - T)

C = 1 + 0.625*(14 - 4) = $7.25 billions. Thus correct answer is c).

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