Consider the consumption function
)If
,a 2 percent demand shock:
A)raises short-run output by 1 percent.
B)raises short-run output by 0.5 percent.
C)raises short-run output by 4 percent.
D)reduces short-run output by 4 percent.
E)has no impact on short-run output.

Question

Consider the consumption function 
)If 
,a 2 percent demand shock:
A)raises short-run output by 1 percent. 
B)raises short-run output by 0.5 percent. 
C)raises short-run output by 4 percent. 
D)reduces short-run output by 4 percent. 
E)has no impact on short-run output.

Quizplus · Accepted Answer

The consumption function reflects the relationship between consumption and disposable income. If there is a 2 percent demand shock, this will increase aggregate demand, which will increase output. The magnitude of the increase depends on the slope of the aggregate demand curve, which in turn depends on the responsiveness of consumption to changes in disposable income. If the consumption function has a high slope, then a small increase in disposable income will lead to a large increase in consumption, which will lead to a large increase in output. Therefore, if the consumption function has a slope of 2 (which means that a 1 percent increase in disposable income leads to a 2 percent increase in consumption), then a 2 percent demand shock will lead to a 4 percent increase in output (2 percent from the initial increase in demand, and an additional 2 percent from the multiplier effect of the increase in consumption and output).

Consider the Consumption Function