Question

A consumption function shows the relationship between consumption and disposable income, holding non-income determinants of consumption constant. Note that the unit of the currency is Zambian Kwacha (K).

Disposable Income	10,000	12,000	14,000
Consumption	11,000	12,000	13,000

a) From the figures provided above find the consumption function.

b) Find the consumption when disposable income is K11,000. How can a household consume more than its disposable income?

c) What is true of every point on the 45^o line? Provide a graph to enrich your explanation.

d) Using the figures above draw the consumption function and identify the dissaving and saving areas.

e) In theory the three methods of calculating national income should be equal. Clearly give reasons for this assumption.

Answer 1

a)

The consumption function is - C = a + b*y

With first 2 data points, we can write 2 equations which will be -

11000 = a + b*10000 - (i)
12000 = a + b*12000 - (ii)

(ii) - (i)

12000 - 11000 = a + b*12000 - (a + b*10000)

1000 = b*2000
b= 0.50 (It is also the marginal propensity to consume).
Substitute b= 0.50 in equation (i)

a = 6000

C = 6000 + 0.50*y is the consumption function.

b)
C = 6000 + 0.50*y
when y = 11000, C = 6000 + 0.50*11000 = 6000 + 5500 = K11,500

Household consumes more than its disposable income by dissaving. That is it can burn its past savings and still consume more than its income.

c)

An economy operates at a level where aggregate expenditure equals output level.The 45 degree line in conjunction with Aggregate expenditure simply represents this equality on graph. This is shown below -

We can see that the point where AE curve (Aggregate Expenditure) intersects 45 degree Y (output) line, the economy's equilibrium is obtained. (AE1, Y1) and (AE2, Y2) are two such equilibrium.

d. Below is the consumption function -

As can be seen, for income level less than 0, there is a dissaving in the economy as the consumers would want to still consume something to stay alive. For income levels more than 0, there is saving in the economy.

e. The three approaches to calculation of GDP are - production ,income and expenditure method. One can see that in theory they will same estimate of GDP with the help of a circular flow of income model. When a consumer spends money on a final good, then that is recorded as a part of GDP through expenditure method. However, it is also recorded as an income for the seller who also pays it to the labor and capital. The production method simply adds the value added at each stage of production. Essentially, one entity's income is another entity's expenditure in an economy. It can be verified by looking at value added method also where the same holds true. Hence, all three methods of calculating national income should be equal.