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Consumption & MPC: Course Title: Intermediate Macroeconomic Theory-I Course Code: ECON2222/ ECO202

The document outlines the Absolute Income Hypothesis proposed by Keynes, which states that as income increases, consumption also increases but at a lesser rate, indicating that the Marginal Propensity to Consume (MPC) is less than one. It explains how changes in government spending impact GDP through the MPC, demonstrating the multiplier effect where a $1 increase in government purchases can lead to a greater overall increase in GDP depending on the MPC. The document also poses questions related to the Absolute Income Hypothesis and the derivation of the government purchase multiplier.

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23 views8 pages

Consumption & MPC: Course Title: Intermediate Macroeconomic Theory-I Course Code: ECON2222/ ECO202

The document outlines the Absolute Income Hypothesis proposed by Keynes, which states that as income increases, consumption also increases but at a lesser rate, indicating that the Marginal Propensity to Consume (MPC) is less than one. It explains how changes in government spending impact GDP through the MPC, demonstrating the multiplier effect where a $1 increase in government purchases can lead to a greater overall increase in GDP depending on the MPC. The document also poses questions related to the Absolute Income Hypothesis and the derivation of the government purchase multiplier.

Uploaded by

nick bd
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CONSUMPTION & MPC

Course Title: Intermediate Macroeconomic Theory-I


Course Code: ECON2222/ ECO202

Course Conductor: Professor Dr. Md Nazmus Sadekin Shaon


Consumption Theory:
Since Keynes lays stress on the absolute size of income as a determinant of consumption, his
theory of consumption is also known as absolute income theory. Further, Keynes put
forward a psychological law of consumption, according to which, as income increases
consumption increases but not by as much as the increase in income. In other words,
Marginal Propensity to Consume(MPC) is less than one.
0<ΔC/ΔY<1

Here, MPC=ΔC/ΔY
Consumption Function is: C = a0 + b Yd
where, C=Consumption
a0= Autonomous consumption, b= MPC, Yd = Disposable Income

C C = a0 +bYd

ΔC
Fig.: Absolute Income
ΔY Hypothesis

0 Y
The Marginal Propensity to Consume and the Multiplier:
Let’s build a simple model to see how the marginal propensity to consume determines the impact of a
change in government spending on GDP. We begin with a hypothetical $1 increase in govt. purchases
of goods and services in an economy which consists of households having identical marginal
propensity to consume(mpc). To simplify the model, households in our model provide goods or
services directly to the govt., so we can imagine that the govt. pays the $1 to one household, say
Household#1. Now household#1 will spend the fraction equal to its mpc of that additional income to
purchase consumption goods, and for simplicity we suppose that the purchase is made directly from
household#2. Seeing its disposable income rise by $1 times mpc, household#2 will purchase
additional consumer goods worth mpc times that amount, say from household #3. We see that the
additional consumption spending at each step of this chain reaction is mpc times the amount at the
prior step.
We summarize this process in a table that shows the incremental spending by each household(HH) at
each step: The govt. purchases $1 which is income to Household-1 which spends mpcX$1; which is
income to Household-2 which spends mpcXmpcX$1; which is income to Household-3 which spends
mpcXmpcXmpcX$1 which is income to Household#4 which spends mpcXmpcXmpcXmpcX$1……. And
so on.
Adding all these up:
1+ mpc+(mpcXmpcX1)+…..dollars which just equals 1/(1-mpc) dollars in total.
The quantity 1/(1-mpc) is called the govt. spending multiplier. It is clear from this that the larger is the
mpc the larger will be the impact of additional govt. spending on GDP. For example, if the mpc is .5
then the impact of each additional dollar of govt. spending on GDP is,
1/(1-MPC)=1/(1-.5)=2
While if the MPC is .9, the impact on GDP is 1/(1-MPC)=1/(1-.9)=10
Or $10 of GDP for every dollar of increased govt. spending. Clearly, the marginal propensity to
consume is a crucial parameter in this analysis.
Questions:

1. Describe the Absolute Income Hypothesis put forward by Keynes.


2. As income increases consumption increases but not by as much as the increase in
income. Illustrate using the Absolute Income Hypothesis.
3. Derive the formula for government purchase multiplier.
4. The larger is the mpc(marginal propensity to consume), the larger will be the
impact of additional govt. spending on GDP. Explain.

Mathematical Problems.

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