The consumption function may be represented in the following relationship:
Where C: consumption spending
a: autonomous consumption spending
On the graft below, draw the consumption function: C=$20+0.75 (Disposable Income).
Consumption is $billions per year.
Disposable income is $100 billion per year.
Answer the following questions:
- At what level of income do households begin to save? Indicate the point on the graph with the letter A.
- By how much does consumption increase when income rises $150 beyond point A? Indicate this new level of consumption with point B.
Economics theory defines consumption as the utilization of goods and services by households (Heim, 2008). The consumption function, therefore, is a line that shows a functional relationship between the level of consumption and disposable income for households. Disposable income is the part of income that households can either consume or save after deducting legal contributions, such as taxes (King, 2010). The consumption function has a 450 line that shows a direct equal relationship between consumption and income (C=I). At no point is consumption at point zero because households consume even when their income is zero. The difference between zero consumption and 20 billion consumed in the graph is autonomous consumption. At this point, households are said to be having negative savings. Autonomous consumption is consumption expenditure that households make when their income is zero.
c = 20 + 0.75(b)
As income rises, the consumption function nears the 450 line and intersects with it at point A. Additionally, the gradient of the 450 line is one meaning that consumption equals income. The household’s action is either saving or dissaving depending on the position of the consumption function with regards to the 450 line. As long as the former is above the latter, then dissaving occurs. Besides, saving starts at the where the two graphs intersect and henceforth increases with an increase in income. Past this point, the household is saving at a rate equal to the gradient of the consumption function. This gradient is known as the Marginal Propensity to Consume (MPC). The MPC gives the proportion of every additional dollar earned that is consumed. Since the MPC is constant, an increase in income will result in an increase in consumption expenditure.
Defined as the natural rise and fall of a country’s economic growth over time, the business cycle is considered a useful means for analyzing an economy. In light of the above statement:
- explain the different phases of a business cycle
A business cycle shows the upward and downward movements in GDP levels of a given long term GDP growth trend (Puu & Sushko, 2006). It is caused by factors such as shocks in the monetary system, supply, and productivity. Other causes include financial busts and bubbles, unexpected changes in spending, and political events. The business cycle is characterized by different periods of expansion and recession in business activities. Expansions occur when economic growth rises together with employment, thus exerting pressure on prices. The climax of expansion is at a point called the peak, where the economy produces the highest allowable level of output given its resources. The economy is also at full employment level, and inflationary pressures are easily identifiable. After the peak level, the economy autocorrects by entering a period of recession, during which economic growth slows down as unemployment increases and pressure on prices decreases. The climax of the recession is the trough. At this point, the economy produces its lowest allowable level of output, given its resources. Unemployment is at an all-time high, and inflationary pressures are at their lowest level. After the trough, the economy once again self-adjusts and enters an expansion period.
The business cycle can be visually presented as shown below:
Graph of Real GDP against Time.
- Explain how both inflation and unemployment contribute to the fluctuation of the business cycle.
Inflation refers to a gradual rise in general price levels, while unemployment refers to a state when people who are able and willing to work cannot find work. While inflation increases during expansion and decreases during a recession, unemployment increases during recession and decreases during an expansion (Auerbach & Gorodnichenko, 2012). Adaxially, unemployment leads to scarcity since few goods and services are produced. As such, economic growth decreases since consumption is also low, which creates a ‘shortage’ in the economy and climaxes with an economic trough. On the other hand, inflation, mainly demand-pull, forces the economy into a recession. When economic growth reaches its peak point, the economy is at full employment level while wages are at their highest. The inability of the economy to grow past this point creates demand-pull inflation, and inflationary pressure pushes prices upwards to an unsustainable point from which the economy starts to contract.
Auerbach, A. J., & Gorodnichenko, Y. (2012). Fiscal multipliers in recession and expansion. In Fiscal policy after the financial crisis (pp. 63-98). University of Chicago Press.
Heim, J. J. (2008). The consumption function (No. 0805). Rensselaer Polytechnic Institute, Department of Economics.
King, J. E. (2010). Keynes and ‘psychology.’ Economic Papers: A journal of applied economics and policy, 29(1), 1-12.
Puu, T., & Sushko, I. (2006). Business cycle dynamics. Springer-Verlag Berlin Heidelberg.