Question

1. Explain how changes in net wealth, the price level, interest rates, and expectations alter the consumption function?

Answer 1

(i) As net wealth increases (decreases), ceteris paribus consumption increases (decreases), and consumption function shifts upward (downward).

(ii) As price level increases (decreases), purchasing power decreases (increases) and consumption decreases (increases), therefore consumption function shifts downward (upward).

(iii) As interest rate increases (decreases), borrowing becomes costlier (cheaper) and consumption (the portion that is funded by borrowing) decreases (increases), therefore consumption function shifts downward (upward).

(iv) As consumers expect higher (lower) future income and/or a increase (decrease) in future inflation, current consumption increases (decreases), therefore consumption function shifts upward (downward).