Question

2)What are the main things that shift the consumption schedule?  Note that changes in income don’t shift it because that is built into the slope.  List the things and think about the intuition of how they would affect your own consumption.

  

       

3)Consider Investment Demand. What is on the vertical axis? Note: I recommend thinking of the interest rate firms pay to borrow rather than the expected return (the book uses both terms on the vertical axis).  Explain why firms do more investment expenditure when the interest rate drops.

Answer 1

2 ) A Keynesian consumption function can be expressed as -

Where C = a + b Y_d

• C = Total consumption expenditure
• a = autonomous expenditure
• b = Marginal propensity to consume
• Y_d = Level of disposable income

As you can clearly see changes in income don't shift the consumption schedule as it's built into the slope

So, the things that affect our own consumption will be :

• Consumer confidence

If there is a fear of a recession where there will be higher unemployment and lower output, consumers like us will get pessimistic about the future and decrease consumption expenditure. This will shift the consumption schedule to the left ( upward )

Similarly, during an economic boom, there will lower unemployment and higher output, consumers like us will get optimistic about the future and increase consumption expenditure. This will shift the consumption schedule to the right ( downward )

• Amount of wealth

Wealth plays an important role in determining the level of consumption expenditure. When I inherit a lot of wealth or if there is an opportunity to inherit wealth in the future, consumers like us tend to consume more in the present. This will shift the consumption schedule to the right ( downward )

Therefore, if we own a home or a stock, and prices of those assets suddenly go up or we assume it to go up, we will tend to consume more in the present.

This fact that higher wealth leads to higher consumption is sometimes referred to as the ' wealth effect '

An exactly opposite situation when those prices go down and suddenly people will consume less in the present. Here, this decrease in wealth will shift the consumption schedule to the left ( upward )

• The level of consumer indebtedness

If there is an overall rise in debt for the consumers, consumers tend to save more of their income and consume less and lesser amounts of their income. This will reduce consumption in the present as people will try to pay their debts. Here, this increase in consumer indebtedness will shift the consumption schedule to the left ( upward )

On the other hand, if there is a fall in debt for the consumers, consumers tend to consume more of their income and save less of their income. This will result in an increase in consumption in the present. This will shift the consumption schedule to the right ( downward )

3 ) On the  vertical axis of the investment demand schedule what we have is called the ' rate of interest '

As interest rate can be termed as the cost of borrowing, therefore

• Fall in interest rates reduces the burden of the cost of borrowing. So, if there is a higher interest rate for every firm it needs to be accompanied by a higher rate of return for the investment to get profitable
• Therefore when there is a fall in the interest rate the find it profitable to increase their demand for investment. That's why firms do more investment expenditure when the interest rate drop