Question

If consumption is C = a + b(Y – T) – θr, where θ > 0, then, other things equal, monetary policy is more effective, and fiscal policy is less effective, in changing the level of output compared to when consumption is given by a standard Keynesian consumption function of the form C = a + b(Y – T).

Answer 1

Ans:

In the standard keynesian consumption function, the consumption is dependent only on the disposable income which is left after payment of taxes (Y-T).

While, in the second consumption function, consumption depends upon disposable income (Y-T) and Interest rates.

Consumption is negatively related to interest rates because as interest rate rises, we will spend less and save more to gain the interest on it.

The consumption function C = a + b(Y – T) – θr is better with monetary policy than fiscal policy because of the following reasons:

• If central banks adopts expansionary monetary policy, the interest rates falls. Due to a fall in interest rates, consumption rises. Also, with expansionary monetary policy, the income level also rises, in short, disposable income rises (Y rises and T is constant), then total consumption expenditure rises.
• If government uses expansionary fiscal policy, it will lower the taxes, the disposable income rises but due to the adoption of expansionary fiscal policy, interest rate rises in the economy, which decreases the consumption expenditure. The fiscal policy looses its effectiveness in this model.