Question

Assume a nation has an output level of 150 units per year, and that consumption is also 150. Suppose there is a sudden temporary drop in GDP by 16%. What does the long-run consumption path look like if this country has access to global financial markets with an interest rate of 5%?

Answer 1

Given that at Output = 150, the economy consumes 150 units, i.e., both the Marginal Propensity to Consume (MPC) and the Average Propensity to Consume (MPC) is 1. Thus, initially, the consumption function is of the form:

                                                          C = Y

Thus, people consume (C) whatever they produce (Y).

Now, with a GDP shock of 16%, the output level drops to 126. [150 – 16% of 150]

Thus, at Output Level = 126, the economy is facing a consumption deficit of (150 – 126) units = 24 units.

The households would now borrow the unavailable amount from the international financial market at the rate of interest, r = 5% or 0.05.

Hence, New Consumption = 126 + 24(1 + 0.05)

Thus, the long-run consumption function takes the form:

C(Y,r) = C_bar + (C_bar - Y)(1 + r)