Answer to Question #89816 in Macroeconomics for Thurga

Question #89816
1) How to derive consumption function and saving function in the form of national income? 2) How to calculate inflationary gap or deflationary gap based on full employment level of income level?
Expert's answer

1) Consumption function (C) contains two parts. The First part consists of a consumption that is independent of income and is called autonomous consumption (a) and the other part contains the consumption which is dependent upon national income (Y) is calculated using marginal propensity to consume (b). It is expressed as:

                                                                                      C = a + b(Y)

 Saving function is totally dependent on national income (Y) as nothing cannot be saved if there is no income. It is expressed as the proportion of income which is saved and this depends on marginal propensity to save (mps, s). It is given as:

                                                                                         S = sY

2) Inflationary gap occurs when aggregate demand exceeds aggregate supply while the economy is already operating at full employment level. This causes a great increase in price level which creates inflationary conditions in the economy.

 Deflationary gap arises when there is a difference between potential output at full level of employment and the actual level of output in the economy as the resources of the economy are not being used to their optimum level. This also shows the deficiency of aggregate demand over aggregate supply in the economy.

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