Question

Given the following consumption fiction, C= 100 + 0.6YD calculate by how much induced consumption spending will decrease if the government increases taxes by R100

Answer 1

Original Consumption function, $C = 100 + 0.6 Yd$

Lets call this consumption function be $C_1 = 100 + 0.6 Yd = 100+ 0.6(Y - T1)$

Now if new Taxes levied are $T_2 = T_1 + 100$

Therefore. new consumption function is$C_2 = 100 + 0.6 Yd = 100 + 0.6 (Y - T_2)$

$C_2 = 100 + 0.6(Y - T_1 -100)$

$= 100 + 0.6(Y - T_1) - 60 = 40 + 0.6(Y - T_1)$

Therefore, change in consumption spending is $C_2 - C_1 =40 + 0.6(Y - T_1) -100 - 0.6(Y - T_1) = -60$

Hence, as government increases taxes by $R 100$ the consumption spending decreases by $R 60.$

Therefore, this tax increase induces consumption spending to decrease by $R 60$