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Questions and Answers
What does the variable 'b' in the consumption function represent?
What does the variable 'b' in the consumption function represent?
How is the Average Propensity to Consume (APC) calculated?
How is the Average Propensity to Consume (APC) calculated?
What happens to the Average Propensity to Consume (APC) as income increases?
What happens to the Average Propensity to Consume (APC) as income increases?
Which equation represents the saving function?
Which equation represents the saving function?
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What is indicated by a positive saving amount in the saving function?
What is indicated by a positive saving amount in the saving function?
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Which of the following statements is true regarding the Marginal Propensity to Consume (MPC)?
Which of the following statements is true regarding the Marginal Propensity to Consume (MPC)?
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What does induced consumption refer to?
What does induced consumption refer to?
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In the consumption function, what does the curve's slope represent?
In the consumption function, what does the curve's slope represent?
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What is the formula used to calculate Average Propensity to Save (APS)?
What is the formula used to calculate Average Propensity to Save (APS)?
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How does Marginal Propensity to Save (MPS) behave as income increases?
How does Marginal Propensity to Save (MPS) behave as income increases?
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Which of the following statements correctly reflects the relationship between Average Propensity to Save (APS) and Average Propensity to Consume (APC)?
Which of the following statements correctly reflects the relationship between Average Propensity to Save (APS) and Average Propensity to Consume (APC)?
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What is one implication of the Psychological Law of Consumption?
What is one implication of the Psychological Law of Consumption?
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What does the equation MPC + MPS = 1 signify?
What does the equation MPC + MPS = 1 signify?
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According to the Psychological Law of Consumption, what happens when income is zero?
According to the Psychological Law of Consumption, what happens when income is zero?
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What might an overproduction situation lead to in the economy according to the psychological law of consumption?
What might an overproduction situation lead to in the economy according to the psychological law of consumption?
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What is a characteristic of secular stagnation as described in the Psychological Law of Consumption?
What is a characteristic of secular stagnation as described in the Psychological Law of Consumption?
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Which of the following is a requirement for the Psychological Law of Consumption to hold true?
Which of the following is a requirement for the Psychological Law of Consumption to hold true?
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What result does the Psychological Law of Consumption indicate regarding government intervention?
What result does the Psychological Law of Consumption indicate regarding government intervention?
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How would one calculate Marginal Propensity to Save (MPS)?
How would one calculate Marginal Propensity to Save (MPS)?
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Which statement about the Psychological Law of Consumption is accurate?
Which statement about the Psychological Law of Consumption is accurate?
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What does a rise in the marginal efficiency of capital (MEC) indicate?
What does a rise in the marginal efficiency of capital (MEC) indicate?
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What happens during periods of a boom in the business cycle according to the trade cycle fluctuation model?
What happens during periods of a boom in the business cycle according to the trade cycle fluctuation model?
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Study Notes
Consumption Function
- The consumption function shows the relationship between consumption and income.
- This relationship is represented by the equation: C = c̅ + bY, where:
- C represents consumption
- c̅ represents autonomous consumption
- b represents the marginal propensity to consume
- Y represents income
- Autonomous consumption (c̅) represents the minimum level of consumption that happens regardless of income.
- Induced consumption is the portion of consumption that is directly affected by income.
- When income increases, consumption increases, but at less than a proportional rate.
- The consumption curve is upward sloping, but it is not parallel to the 45-degree line.
- The slope of the consumption curve represents the marginal propensity to consume (MPC).
Propensity to Consume
- It is a schedule (table) that shows the relationship between different levels of income and different levels of consumption.
- It has two components: average propensity to consume (APC) and marginal propensity to consume (MPC).
Average Propensity to Consume (APC)
- APC is the ratio of consumption to income.
- It represents the percentage of income that is spent on consumption.
- APC is calculated as: APC = C/Y where:
- C represents consumption
- Y represents income
- APC decreases as income increases.
Marginal Propensity to Consume (MPC)
- MPC is the change in consumption as a result of a change in income.
- It represents the proportion of an additional dollar of income that is spent on consumption.
- MPC is calculated as: MPC = ΔC / ΔY, where:
- ΔC represents the change in consumption
- ΔY represents the change in income
- MPC also decreases as income increases.
Saving Function
- The saving function shows the relationship between saving and income.
- This is represented by the equation: S = - c̅ + (1 - b)Y, where:
- S represents saving
- c̅ represents autonomous consumption
- b represents the marginal propensity to consume
- Y represents income
- Saving is negative when income is low because people may borrow or draw down their savings to meet basic needs.
- Saving is positive when income is high.
- The slope of the saving curve represents the marginal propensity to save (MPS).
Propensity to Save
- It is a schedule (table) that shows the relationship between different levels of income and different levels of saving.
- It has two components: average propensity to save (APS) and marginal propensity to save (MPS).
Average Propensity to Save (APS)
- APS is the ratio of saving to income.
- It represents the percentage of income that is saved.
- APS is calculated as: APS = S/Y, where:
- S represents saving
- Y represents income
- APS increases as income increases.
Marginal Propensity to Save (MPS)
- MPS is the change in saving as a result of a change in income.
- It represents the proportion of an additional dollar of income that is saved.
- MPS is calculated as: MPS = ΔS / ΔY, where:
- ΔS represents the change in saving
- ΔY represents the change in income
- MPS also increases as income increases.
- The relationship between MPC and MPS is: MPC + MPS = 1.
The Relationship Between Savings and Income
- As income increases, savings increase at a faster rate.
- This is represented by a saving curve, where the slope of the curve represents the marginal propensity to save (MPS).
- MPS is calculated as the change in savings divided by the change in income.
The Relationship Between Average Propensity to Consume (APC) and Average Propensity to Save (APS)
- APC is calculated as consumption divided by income.
- APS is calculated as savings divided by income.
- The sum of APC and APS always equals 1.
- This means that for every dollar of income, a portion is either consumed or saved.
The Relationship Between Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)
- MPC is calculated as the change in consumption divided by the change in income.
- MPS is calculated as the change in savings divided by the change in income.
- The sum of MPC and MPS also always equals 1.
The Psychological Law of Consumption
- States that as income increases, consumption also increases but by a smaller amount.
- Keynes explained that this happens due to the psychological makeup of individuals.
- As income increases, some people might save more, leading to a smaller increase in consumption.
Assumptions of the Psychological Law of Consumption
- Psychological and institutional factors, tastes, and preferences must remain consistent.
- The economy must be operating under normal conditions, without external shocks like earthquakes or floods.
- The law applies primarily to capitalist economies where government intervention is minimal.
Explanation of the Psychological Law of Consumption
- As income increases, consumption also increases, but at a decreasing rate.
- When income is zero, consumption is still positive as people use their savings or borrow to meet their basic needs.
Implications of the Psychological Law of Consumption
- Strategic Importance of Investment: Investment is crucial to bridge the gap between income and consumption. Without sufficient investment, the economy may face a shortage of demand and a lack of growth.
- Possibility of Overproduction and Unemployment: The difference in the increase of income and consumption can lead to an accumulation of unsold goods. This ultimately leads to overproduction, which causes unemployment as businesses reduce production.
- Refutation of Say's Law: Say's Law is refuted by the psychological law of consumption, which suggests that MPC is always less than 1.
- Decline in Marginal Efficiency of Capital (MEC): Increasing investment can lead to a decline in MEC; expected profitability of investments may decrease due to reduced consumption and demand.
- Underemployment Equilibrium: An underemployment equilibrium occurs when the economy reaches equilibrium before achieving full employment, lacking sufficient demand due to the psychological law of consumption.
- Over-Saving Gap: Advanced economies can experience rapid income growth alongside slower consumption growth, creating an over-saving gap.
- Peaks and Troughs of the Trade Cycle The psychological law of consumption explains trade cycle fluctuations: during booms, high income but low consumption leads to a decline in demand and a downturn.
- Secular Stagnation Consumption growth slower than income can lead to a lack of investment opportunities during secular stagnation.
- State Intervention: Government intervention can be used to stabilize the economy by addressing overproduction and the over-saving gap.
- Inducement to Invest: Underdeveloped countries with higher MPC have greater investment opportunities as income growth results in higher consumption, driving demand.
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Description
This quiz covers the consumption function and its relationship with income, including key components like autonomous consumption and the marginal propensity to consume. Understand how these concepts shape consumption behavior and the graphical representation of the consumption curve. Test your knowledge on how income influences consumption and the implications of this relationship.
