Marginal Propensity to Consume stands for MPC, a macroeconomic calculation that measures how much a person consumes when income increases. Read more about MPC below. Before that, you can watch educational trading videos only on GIC YouTube and get free trading class information on GIC Instagram.

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What is Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume is a macroeconomic calculation that measures how much people spend (or consume) as their income increases. The MPC is an element of Keynesian economic theory, proposed by John Maynard Keynes, who argued that the driving force of an economy is aggregate demand. The total spending on goods and services by the private and government sectors. In the Keynesian economic model, total spending determines all economic outcomes, from production to employment levels. In Keynesian economics, demand is central and often uncertain.

How MPC Works

Economists can examine the MPC across households in different income groups to assess economic inequality or government fiscal policy. The marginal propensity to consume shows how consumption increases with a marginal increase in wealth, which increases an individual’s purchasing power. In turn, this increase in consumption means more money in circulation, and more economic activity and growth. However, the MPC can also reveal critical wealth gaps that could hinder a country’s economic growth.

In low-income households, the propensity to consume with increasing income is higher on average, because they have to spend a larger share of their income on essential living expenses. High-income households tend to have lower MPCs, because they have more disposable income to choose to save or spend, and have established liquid assets.

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What is the Difference between Marginal Propensity to Consume (MPC) and Economic Policy?

With data on household income and household expenditures, economists can calculate the household MPC based on income level. This calculation is important because the MPC is not constant, it varies with income level. Typically, the higher the income, the lower the MPC because as income increases, more of a person's wants and needs are satisfied, and as a result, they save more.

At low income levels, the MPC tends to be much higher because most or all of a person’s income must be devoted to subsistence consumption. According to Keynesian theory, increased investment or government spending raises consumers’ incomes, and they will then spend more. If we know what their marginal propensity to consume is, we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a self-perpetuating cycle through a process known as the Keynesian multiplier.

The greater the proportion of additional income that is spent rather than saved, the greater the effect. The higher the MPC, the higher the multiplier, and the greater the increase in consumption from increased investment. So if economists can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in income.

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Determinants of Marginal Propensity to Consume (MPC)

The following are factors that determine the Marginal Propensity to Consume:
  1. Income level: At lower income levels, an increase in income is likely to result in a high marginal propensity to consume; this is because low-income individuals have many goods/services that they need to purchase. However, at higher income levels, people tend to have a greater preference for saving as they already have most of the goods they need.
  2. Temporary vs. Permanent: If people receive a bonus, they may be more inclined to save this temporary increase in income. However, if they experience a permanent increase in income, they may feel more confident in spending it.
  3. Interest Rates: Higher interest rates can encourage saving over consumption; however, the effect is quite limited because higher interest rates also increase income from savings, reducing the need to save.
  4. Consumer Confidence: If confidence is high, it will encourage people to spend. However, if people are pessimistic (e.g., expecting unemployment/recession), they are likely to delay spending decisions, resulting in a low MPC.

How Do You Calculate Marginal Propensity to Consume (MPC)

You can calculate the MPC by dividing the change in consumption by the change in income. The formula for the marginal propensity to consume looks like this: MPC = Change in Consumption / Change in Income For example, if you receive a $1,000 raise, and you decide to spend $600 of that raise, your marginal propensity to consume is 600 / 1,000 = 0.6. The reciprocal of the marginal propensity to consume is the marginal propensity to save, which is the difference between the increase in income and the marginal propensity to consume. In this example, the marginal propensity to save is 0.4.

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MPC Types

MPC can be classified into three types, namely:
  1. MPC greater than 1
  2. MPC equals 1
  3. MPC is less than 1

MPC greater than 1: When the MPC value is greater than 1, it indicates that changes in income levels have triggered higher levels of consumption that exceed the value of 1. For example, if Ram gets a bonus of 1000 and they spend 2000 on buying goods. Then the MPC will be 2. This expenditure can be attributed to autonomous consumption, which indicates that the expenditure is not based on the level of income.

It is said that a person who does not have a fixed income will feel the need to have enough food to eat and for that they can borrow or break their existing savings. MPC equals 1: When MPC equals 1, it indicates a proportional increase in the level of income leads to an equal increase in the consumption of goods.

MPC less than 1: When MPC is less than 1, there will be a smaller proportional increase in consumption relative to changes in income. That is the explanation of Marginal Propensity to Consume, you can also read other GIC articles to gain more knowledge, such as the explanation of Understanding FOMC (Federal Open Market Committee), only in the GIC Journal.

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