Exchange Rates and Commodity Price - Dissertation Example

Marginal propensity to consume is can be defined as the incremental change in consumption that results from a change in income. That is, the increase in consumption if there is a unit increase in incomes is known as the marginal propensity to consume. This paper explores the marginal propensities to consume in the US and UK economies. Essentially, the validity of the Keynesian theory of consumption is the focal point. The significance of the theory lies in the degree of efficacy of income tax policies.

If there is a high Marginal Propensity to Consume, then tax cuts will significantly increase consumer spending in aggregate. Tax increases similarly will substantially reduce aggregate consumption expenditure. We shall first do a review of the fundamentals of Keynesian consumption theory and look at the developments this theory has undergone since its inception. Particularly, we shall look at Keynes (1936), Duesenberry (1948), Modigliani and Brumbergh (1955) and Friedman (1956) to develop an understanding of what to expect when we start exploring the data.

Then, we shall proceed to estimate the marginal propensity to consume first under the hypothesis of the consumption function postulated by Keynes. Then noting possible shortcomings, we shall move forward by correcting these problems and reformulating the central hypothesis before re-estimating. We shall use data from the US and UK economies to derive our conclusions. The fundamental contribution of this paper is likely to emerge in its estimation of the relationships with a data set that is updated until the early months of 2011.

Additionally, the study is likely to reveal some interesting contrasts between the UK and US economies. We start the paper by briefly reviewing the theoretical underpinnings of the hypotheses that we shall eventually test, in the next section. 2. ECONOMIC THEORYThe first step towards the development of a modern macroeconomic theory of consumption dates back to Keynes’ (1936) General theory where he provides the following psychological basis for consumption behaviour.