International Economics Assignment on Consumption Function and Business Cycle

This assignment discusses the consumption function and business cycle in international economics. It explains the relationship between disposable income and consumption, MPC, and the phases of the business cycle. It also discusses the impact of inflation and unemployment on the business cycle.

Page 1 of 9
INTERNATIONAL ECONOMICS
ECONOMICS ASSIGNMENT

Page 2 of 9
Table of contents
Question number 1.....................................................................................................................3
Question number 2.....................................................................................................................5
Reference....................................................................................................................................8

Page 3 of 9
Question number 1
Consumption function can be written in the form
C= a+b (disposable income)
Now disposable income is the income of the consumer after all the taxes are paid to the
government. The full form of MPC is Marginal Propensity to Consume which means the
proportion of the additional income which is spent on consumption (Mankiw, 2014). The
autonomous consumption part or the intercept of the equations are the basic consumption of
the consumer when the disposable income is zero.
a)
0 100 200 300 400 500 600
0
50
100
150
200
250
300
350
400
450
500
Consumption function
Disposable income
Consumption A(200,200)
Figure: the consumption function
(Source: Developed by the learner)
The blue line is called the 45degree line or the income line of the consumer. At the
initial stages, the consumer consumes more than his income. In this case, the blue line lies
below the red line. However, after the income reaches $200, the consumption also becomes
$200. At this point, the consumer consumes equal to what he earns.

Page 4 of 9
Thus, after A($200,$200) the consumer starts to save money. In other words, after this point,
the blue line lies above the red consumption curve.
0 100 200 300 400 500 600
0
50
100
150
200
250
300
350
400
450
500
Consumption function
Disposable income
Consumption
A(200,200)
B( 335,350)
Figure 2: The point where the income is greater than consumption
(Source: Developed by the learner)
b) Beyond the point of A, with an increase in the income of the consumer, the consumption
increases as per the MPC of the consumer.
Here, in this case, the MPC is 0.9
This means that with additional one unit increase in the income of the consumer the
consumption will increase 0.9 units. Therefore, an increase of $150 worth of income will
increase the consumption by
$(150*.9) = $135
This can also be checked putting the value of income in the consumption equation as well.
At income level of $200
C= $20+0.9*$200= $200

Page 5 of 9
Now increase of $150 in the income
C= $20+ 0.9 ($350) =$335
Thus the changes in the consumption is = (335-200) = $135
Therefore, $150 increase in income beyond the point A increases the consumption by $135.
Question number 2
Business cycle
The business cycle is referred to as the real output map of an economy wherein the
production of the economy rise and fall with the time. This is the map of the actual output of
the economy that deviates from the potential output at each point in time. The fluctuations in
the GDP of the country normalised by the inflation rate shows the business cycle of a specific
economy.
Unemployment
Unemployment is referred to as the proportion of the workforce of an economy who does not
have the opportunity to contribute to the production of the economy. As per the definition,
the unemployment of an economy is measured through the following formula,
Unemployment rate= (number of people unemployed/ Total size of the labour force of the
economy)*100
Inflation rate
The inflation rate is the rate at which the price level of the economy increases over time. The
direct consequence of rising inflation in the economy is the falling purchasing power of the
consumers. Another big impact of inflation rate is on the growth of the economy. The
inflation rate of any economy is generally controlled by the central banks so that economic
growths can be smooth. However, it is to be noted that the increase in the inflation rate with
the increase in the GDP of the economy is inevitable.
a) Different phases of the business cycle

Page 6 of 9
Figure 3: The business cycle of an economy
(Source: Mankiw, 2014)
There are four phases of the business cycle which involve, the expansion, peak, contraction
and the trough. Expansionary phase of the business cycle is when the economy is growing.
Mankiw (2014) stated that, at this phase, the economy grows above the potential GDP of the
economy. In this phase, the economy grows thereby increasing the employment, production,
and inflation in the market. Subsequently, comes the phase where the growth of the economy
reaches its peak. This is also the part of the business cycle where the economy starts to
contract. Agénor and Montiel (2015) highlighted that increased inflationary pressure is the
reasons for the drop in the production and the employment in the economy during this stage.
The price level of the economy also starts to reduce at this stage. In addition to that, the level
of employment also starts falling during this phase of business cycle. The last phase of the
business cycle is the trough when the economic contraction stops and preparers for expansion
in the next phase.
b) Explanation of the contribution of inflation and unemployment in the business
cycle
At the potential level of GDP, when the economy starts to grow, the number of the economic
transaction also starts increasing. From the quantity theory of money, we know that,
MV=PY
Where M is the money supply in the economy
V is the velocity of money

Page 7 of 9
P is the price level and Y is the output of the economy.
Now, from that equation,
Y= MV/P
Now given the price level and velocity of money when the price level goes up due to
inflation,
The overall output starts falling leading to contraction. With the increase in the economic
production or GDP, the inflation also increases. This increased inflation, after reaching the
peak of the business cycle, affects the GDP and hence GDP starts to fall leading to
contraction of the economy.
Again, unemployment when decreases, increases more product for the economy and hence
economy starts to grow. This way the reduction in the unemployment rate, gives rise to the
GDP of the economy.
Figure 4: The relationship between the GDP and unemployment
(Source: Agénor and Montiel, 2015)
The figure 4 shows that with an increase in the unemployment the GDP growth rate falls and
hence economy contracts. However, after reaching peaks in the business cycle the
unemployment starts increasing thereby decreasing the growth of the economy leading to

Page 8 of 9
economic contraction. The relationship between GDP growth and the unemployment rate has
also been shown by the Okun’s law which states that with 1% increase in the GDP, the
unemployment reduces by 0.5%. Thus, both the unemployment rate of the economy and the
inflation rate influence the business cycle on an economy.

Page 9 of 9
Reference
Agénor, P.R. and Montiel, P.J., 2015. Development macroeconomics. Princeton University
Press.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.