4. What is consumption function and saving function? What is marginal propensity to consume (mpc)? a)...

4. What is consumption function and saving function? What is marginal propensity to consume (mpc)?

a) How is saving related to mpc? Is saving related to the real interest rate (r)?

(b) Why is investment negatively related to r?

Solutions

Expert Solution

Consumption Function: Consumption function shows functional relationship between consumption and income of consumer. It was developed by Keynes or it is also called psychological law of consumption.

C = f(Y)

C = a +bY

a is autonomous consumption and b is MPC.

Saving function: Saving function shows functional relationship between saving and income. Saving is positively related to the income. Saving rises as income of consumer rise.

S = F(Y)

Marginal Propensity to consume (MPC): It proportion of income which is consumed or Change in consumption divided by the change in income is called Marginal Propensity to Consume.

Increase in MPC reduces saving of consumer.

MPC + MPS=1

MPS = 1- MPC.

saving is positively related to interest rate. Rise in real interest rate increases returns on saving.

Investment is made through borrowed fund . Hence, interest is a kind of cost to firm. Rise in interest rate automatically increases cost of borrowing fund for making investments. Hence, investment is inversely related to the interest rate.

Rahul Sunny answered 1 year ago

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