Problem #2: A Consumption Function: C = Co + MPC(Yd). Suppose that autonomous consumption is inversely related to the interest rate. It follows that as…
a. interest rate falls, consumption falls
b. interest rate rises, saving falls
c. interest rate rises, consumption falls
d. disposable income rises, autonomous consumption rises
e. none of the above
The answer I learned was C. So does the consumption refer to autonomous consumption.
Autonomous consumption is your Co term. Answer c. is correct; as r rises, Co falls, therefore C falls.
To understand why answer c. is correct, let's break down the given consumption function:
C = Co + MPC(Yd)
Where:
C = Consumption
Co = Autonomous consumption (independent of disposable income Yd)
MPC = Marginal Propensity to Consume (the fraction of disposable income that is consumed)
Yd = Disposable income
Answer c. states that as the interest rate rises, consumption falls. This is indeed correct because the interest rate is inversely related to autonomous consumption (Co).
When the interest rate rises, Co (autonomous consumption) decreases. This means that the initial level of consumption (which does not depend on disposable income) is lower. As a result, the overall consumption (C) also decreases because it is the sum of autonomous consumption (Co) and the consumption that is impacted by changes in disposable income (MPC(Yd)).
So, when the interest rate rises, both autonomous consumption (Co) and overall consumption (C) decrease. This matches the explanation provided in answer c.
Therefore, the consumption referred to in answer c. is indeed the overall consumption, considering the effect of both autonomous consumption (Co) and the consumption that depends on disposable income (MPC(Yd)).