Answer Happy

Problem 3.2 Consider the aggregate consumption function: C = Co +C, (Y –T) – C, a) Which parameter refers to the marginal propensity to consume? Assuming a strictly concave utility function, set up the household's consumption maximization problem and explain why the marginal propen- sity to consume is assumed to be positive and smaller than one. b) Using the terms substitution effect and income effect to explain how a consumer who inter-temporally maximizes consumption reacts to an increase in the interest rate. Does it matter whether the consumer is a creditor or a borrower? What is the reaction when the interest rate decreases? c) Based on your reasoning in part b), explain why the parameter Cg in the aggregate consumption function is assumed to be positive.