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The Marginal Propensity to Consume

The way households react to changes in income depends on their marginal propensity to consume (MPC). The MPC is the fraction of each additional earned dollar that households spend on consumption, or the change in consumption spending divided by the change in income:

If you receive a $1,000 raise and you plan to spend $900 of that increase, your MPC is 9/10, or .90. In other words, you'll spend 90 percent of any additional income you receive. In our hypothetical economy the marginal propensity to consume is 3/4, or .75. Note that in Exhs. 1 and 2, for every $100 billion increase in GDP (income), consumption spending increases by $75 billion:

You can relate the marginal propensity to consume to the consumption function easily if you know that the slope of any line is, by definition, the vertical change divided by the horizontal change. The slope of the consumption function is the change in consumption spending divided by the change in income, which is precisely how we define the marginal propensity to consume. In other words, the slope of the consumption function is equal to the economy's MPC. If the MPC in our example were higher (.90 instead of .75, for example), the slope of the consumption function would be steeper; if the MPC were lower (perhaps .50), the consumption function would be flatter.

According to our consumption function, only part of an increase in income is spent; the rest is saved. The marginal propensity to save (MPS) is the fraction of each additional earned dollar that is saved, or the change in saving divided by the change in income:

Calculating MPS is no problem once you know MPC. The marginal propensity to consume and the marginal propensity to save have to add up to 1.00, or 100 percent: If MPC is .75, you know that MPS must be .25. That is, 75 cents from each additional dollar is spent, and 25 cents is saved.

As you study Exhs. 1 and 2, keep in mind that the consumption function indicates the desired—or planned—levels of consumption, not necessarily the actual levels. Just as the demand curves we encountered in Chapter 3 showed the amount of a product consumers are "willing and able to buy at various prices," the consumption function shows the amounts that households desire to consume at various income levels. How much of a product people actually buy depends on the prices that actually prevail. Similarly, the actual level of consumption depends on the actual level of income in the economy.

 
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