what happens when mpc decreases?

In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income.

MPC is depicted by a consumption line, which is a sloped line created by plotting the change in consumption on the vertical "y" axis and the change in income on the horizontal "x" axis.

The marginal propensity to consume is equal to ΔC / ΔY, where ΔC is the change in consumption, and ΔY is the change in income. If consumption increases by 80 cents for each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8.

Suppose you receive a $500 bonus on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new suit and save the remaining $100, your marginal propensity to consume will be 0.8 ($400 divided by $500).

The other side of the marginal propensity to consume is the marginal propensity to save, which shows how much a change in income affects levels of saving. Marginal propensity to consume + marginal propensity to save = 1. In the suit example, your marginal propensity to save will be 0.2 ($100 divided by $500).

If you decide to save the entire $500, your marginal propensity to consume will be 0 ($0 divided by 500), and your marginal propensity to save will be 1 ($500 divided by 500).

Given data on household income and household spending, economists can calculate households’ MPC by income level. This calculation is important because MPC is not constant; it varies by income level. Typically, the higher the income, the lower the MPC because as income increases more of a person's wants and needs become satisfied; as a result, they save more instead. At low-income levels, MPC tends to be much higher as most or all of the person's income must be devoted to subsistence consumption.

According to Keynesian theory, an increase in investment or government spending increases consumers’ income, and they will then spend more. If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a continuous cycle via a process known as the Keynesian multiplier. The larger the proportion of the additional income that gets devoted to spending rather than saving, the greater the effect. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment; so, if economists can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in incomes.

A high MPC indicates that the proportion of increased income spent on goods and services approached the actual amount of that increase. Conversely, a low MPC means an individual spent less of that increase in income and instead, put the money into savings.

In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers). The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar (without borrowing or using savings). If the extra money accessed by the individual gives more economic confidence, then the MPC of the individual may well exceed 1, as they may borrow or utilise savings.

The MPC is higher in the case of poorer people than in rich.[1]

According to John Maynard Keynes, marginal propensity to consume is less than one.[2]

Mathematically, the M P C {\displaystyle {\mathit {MPC}}} function is expressed as the derivative of the consumption function C {\displaystyle C} with respect to disposable income Y {\displaystyle Y} , i.e., the instantaneous slope of the C {\displaystyle C} - Y {\displaystyle Y} curve.

or, approximately,

Marginal propensity to consume can be found by dividing change in consumption by a change in income, or M P C = Δ C / Δ Y {\displaystyle {\mathit {MPC}}=\Delta C/\Delta Y} . The MPC can be explained with the simple example:

Here Δ C = 50 {\displaystyle \Delta C=50} ; Δ Y = 60 {\displaystyle \Delta Y=60} Therefore, M P C = Δ C / Δ Y = 50 / 60 = 0.83 {\displaystyle {\mathit {MPC}}=\Delta C/\Delta Y=50/60=0.83} or 83%. For example, suppose you receive a bonus with your paycheck, and it's $500 on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new business suit, your marginal propensity to consume will be 0.8 ( $ 400 / $ 500 {\displaystyle \$400/\$500} ).

The marginal propensity to consume is measured as the ratio of the change in consumption to the change in income, thus giving us a figure between 0 and 1. The MPC can be more than one if the subject borrowed money or dissaved to finance expenditures higher than their income. The MPC can also be less than zero if an increase in income leads to a reduction in consumption (which might occur if, for example, the increase in income makes it worthwhile to save up for a particular purchase). One minus the MPC equals the marginal propensity to save (in a two sector closed economy), which is crucial to Keynesian economics and a key variable in determining the value of the multiplier. In symbols, we have: Δ C Δ Y + Δ S Δ Y = 1 {\displaystyle {\frac {\Delta C}{\Delta Y}}+{\frac {\Delta S}{\Delta Y}}=1} .

In a standard Keynesian model, the MPC is less than the average propensity to consume (APC) because in the short-run some (autonomous) consumption does not change with income. Falls (increases) in income do not lead to reductions (increases) in consumption because people reduce (add to) savings to stabilize consumption. Over the long-run, as wealth and income rise, consumption also rises; the marginal propensity to consume out of long-run income is closer to the average propensity to consume.

The MPC is not strongly influenced by interest rates; consumption tends to be stable relative to income. In theory one might think that higher interest rates would induce more saving (the substitution effect) but higher interest rates also mean than people do not have to save as much for the future.

Economists often distinguish between the marginal propensity to consume out of permanent income, and the average propensity to consume out of temporary income, because if consumers expect a change in income to be permanent, then they have a greater incentive to increase their consumption.[3] This implies that the Keynesian multiplier should be larger in response to permanent changes in income than it is in response to temporary changes in income (though the earliest Keynesian analyses ignored these subtleties). However, the distinction between permanent and temporary changes in income is often subtle in practice, and it is often quite difficult to designate a particular change in income as being permanent or temporary. What is more, the marginal propensity to consume should also be affected by factors such as the prevailing interest rate and the general level of consumer surplus that can be derived from purchasing.

The MPC will invariably be between 0 and 1.

The marginal propensity to consume measures the change in consumption/change in disposable income

The marginal propensity to consume can also be shown by the slope of the consumption function:

Average propensity to consume (APC)

The average propensity to consume = consumption / income

It is possible that consumers could have a marginal propensity to consume of greater than. If income increases £10, in certain circumstances, they may increase spending by £11 – they finance this extra spending by borrowing. More likely is a fall in income of £10, doesn’t cause a fall in spending because people need to maintain certain spending patterns (known as autonomous consumption).

If a worker gains an extra £100, what will be the marginal propensity to consume on UK goods?

There will be three factors (known as withdrawals) which limit the marginal propensity to consume on domestic goods:

These three withdrawals can limit the marginal propensity to consume.

The multiplier effect states that an injection into the circular flow (e.g. government spending or investment) can lead to a bigger final increase in real GDP. This is because the initial injection leads to knock on effects and further rounds of spending.

The marginal propensity to consume will determine the size of the multiplier. The higher the MPC, the greater the multiplier effect will be. If the marginal propensity to consume is 0, there will be no multiplier effect.

The multiplier (k) = 1/1-mpc

For example, if the government pursues expansionary fiscal policy (higher G) but consumer confidence is very low, then there will be a high propensity to save and a low marginal propensity to consume; this will limit the effectiveness of fiscal policy because the injection will lead to only limited increases in spending and aggregate demand.

Marginal propensity to consume and tax cuts

One important issue regarding MPC is the impact of tax cuts. If the government wished to pursue expansionary fiscal policy, they may cut the higher rate of income tax (45% on income over £150,000). However, the mpc is likely to be low at this income level. However, if the income tax threshold is increased, there is likely to be a greater economic stimulus because, at those income levels, the MPC is higher.

See: best form of economic stimulus

The marginal propensity to save (MPS) = the amount of extra income that is saved.

In a closed economy (without taxes). The mpc + mps = 1.

The formula used to calculate marginal propensity to consume is change in consumption divided by change in income, or, MPC = ∆C/∆Y. To make this calculation, you first must determine the change in income and the resulting change in spending (consumption). If someone's income increases by $5,000 and their spending increases by $4,500, the calculation would be made in this way:

MPC = 4,500/5,000. MPC = .9 or 90%

Keynes formally introduced the concept of MPC in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes argued that all new income must either be spent, as with consumption, or invested, as with savings.

Keynes understood that the classical thinking which held that supply would create its own demand did not always work. He noted that the main problem was a lack of aggregate demand. He believed that government spending could add to aggregate demand and that this fiscal stimulus would create a multiplier effect. This effect would result from increases in income and consumer spending that caused a chain reaction of spending by various other beneficiaries of the spending.

Take an employee of ABC Company. They receive a raise in salary. Their spending goes up as a result. What is MPC in this instance? Since the formula for MPC is change in consumption divided by change in income, you must first determine those two changes.

For change in income, the salary rose from $65,000 to $75,000. The change is $10,000 ($75,000 minus $65,000).

For change in consumption, determine levels of spending before and after the salary increase. Before the increase, the employee spent $60,000 of the $65,000 on goods and services. They put the remaining $5,000 into savings. After the salary raise to $75,000, they spent $65,000 on goods and services. The change in consumption is $5,000 ($65,000 minus $60,000).

To calculate marginal propensity to consume, insert those changes into the formula:

MPC = ∆C/∆Y

MPC = 5,000/10,000

MPC = .5 or 50%

This means the individual spent 50% of their added income on goods and services.

An MPC equal to one means that a change in income (∆Y) led to the same proportionate change in consumption (∆C). That is, a person spent 100% of the additional income on goods and services and saved none of it.

An MPC less than one means that a change in income produced a proportionally smaller change in consumption. A person spent less than the added income received.

An MPC equal to zero means that a change of income led to no change in consumption. So, a person spent none of the change in income and, instead, put it into savings.

An MPC that is higher than one means that additional income led to spending that surpassed the amount of additional income.