Question

For the next three questions, go back to the original consumption function (C = 100 + 0.2(Y-T)),
and suppose instead that there is a decrease in tax (assume no change in government spending now).
What will the effect be on consumption. (You can answer this based on your intuitive
understanding of the model, or you can answer it by plugging numbers of your choosing into the
model to compute an answer mathematically.)

Answer 1

Let's try to answer the question on how the consumtion is effected with a decrease in tax both theoritacally based on Income-Expenditure Keynes Model and mathematically using the given equation.

As per the understanding of the model, person’s current income determine his consumption spending. Current Income or Net disposable Income left for Consumption is the income left after paying taxes determines the level of current consumption. When tax is reduced, the disposable income increases, consumers will increase their planned expenditures. There is a positive relationship between disposable income and consumption spending is called the consumption function. As income increases, consumption will also increase, but not as rapidly as income. This indicates that the marginal propensity to consume is less than one; some fraction of additional income is allocated to saving. This indicates that as income expands, households increase their consumption by less than their increase in income.

Mathematically, Assuming Y = 500 and Tax reduced from 50 to 10.

C1 = 100 + 0.2 (500-50) = 190

C2= 100 + 0.2 (500-10) = 198

Even mathematically it proves that with decrease in tax, Consumption increases.