Question

Question:
Draw and explain the economic models such as consumption function and three equation model

Answer 1

(a) CONSUMPTION FUNCTION MODEL

In economics, consumption function defines a relation between consumption and disposible income or gross national income. It was introduced by Keynes in 1936, and hence called Keynesian consumption function. The classic consumption function defines that the consumer spending is wholly determined by the income and the changes in income. Thus the aggregate savings should increase proportionally as the GDP grows over time. The consumption function my be represented as

C = A+MD

C = Consumer spending

A = Autonomous consumption

M = Marginal propensity to consume

D = Real disposible income

The function is assumed to be stable and static where all expenditure are passively determined by the level of national income. Thus consumption function and independent investment must remain constant for national income to reach equilibrium.

Accordin to Keynes, the consumption function should have the following characteristics

a) Aggregate real consumption expenditure is a stable function of real income

b) The Marginal propensity to consume [MPC] ie; the slope of consumption function must be btween 0 and 1

c) The Average Propensity to Consume [APC] or the proportion of income spent on consumption should be decreasing as income increases.

d) MPC decreases itself or remains constant as income increases

Refer to the figure above

The consumption function PQ is a straight line and OT makes an angle of 45 degree with the origin.. Thus the consumption function satifies all the characteristics.

a) A stable relation exists between C and Y

b) The slope of PQ gives the MPC, with a positive slope. The consumption function PQ is flatter than the 45 degree line and slope is less than that line. Thus slope of PQ = MFC and hence MPC is between 0 and 1

c) At P, APC is infinity. and at T, APC is one. To the left of T, APC is less than 1 and to the right, APC is greater tha 1.ie; to the right of T, C<Y Thus APC decreases from left to right

d) The consumption function is a straight line and the slope is constant funtion at all times ie; cinstant MFC

B) THREE EQUATION MODEL

The 3 equation model is based on three curves,

a) IS curve - Equilibrium in the goods market

b) PC curve - Unemployment - inflation relationship

c) MR curve - How the central bank refers to the shocks

a) IS curve

The equilibrium condition is given by

Y = C+I+G

At any point, the IS curve implies market equilibrium which is the equilibrium condition of Keynesian model. Thus it represents the investment - saving curve

'b) PC curve or the Philips curve

It defines that the inflation and unemployment have a stable and inverted relationship. Thus with economic growth comes the inflation which leads to more jobs and less unempoyment

c) MR curve

It defines the relation between the marginal revenue received by a firm for selling its output and the quantity of utput sold. A firm maximises the profit by producing the quantity of output sold at the intersection of marginal revenue curve and the marginal cost curve

The MR curve for a market with no market control is horizontal The MR curve for a market with market control is negatively sloped and lies below the average revenue curve.

Thus the above three represents the three equation model