If you get a 100 dollar raise and spend 80 dollars out of it, then your Marginal Propensity to Consume is 80/100 or 0.80.
If you break up the term – Marginal Propensity to Consume – you will find that the Marginal stands for the fact that this number deals with an increase in a base, Propensity stands for a “tendency”, and Consume stands for money that you will go out and spend.
So, in effect, it is a fraction that describes how likely you are to spend any extra money that you get, as opposed to saving it. The higher the number – the more likely you are to spend the extra money.
This number should always be between 0 and 1 because theoretically, you can’t spend more than you earn.
I don’t think that is always true.
In the past few years, I have seen several people who are buoyed by salary raises and spend more than the raise itself. It is not very apparent that they are spending more than the raise because sometimes the difference between capital and credit gets blurred and they get easy financing to boost their spending capacity.
There are several factors that impact a person’s Marginal Propensity to Consume and these are external as well as internal.
External factors that impact Marginal Propensity to Consume
- Recession: In recessionary times people are more likely to save their extra income than spend it. The US Savings Rate is at a 14 year high and this has a lot to do with the current great recession. Similarly, in times of boom, there is a general euphoria, which loosens the purse strings and people are more willing to spend than to save. So, the economic cycle has a lot to do with the Marginal Propensity to Consume.
- Social Security Net: In developed economies, there is a social security net that offers protection to people and they have something to fall back on. Most developing economies lack such a safety net and therefore people generally tend to save more. They know that in a rainy day, they will just have their own savings to fall back upon.
- Volatility: Countries which face more volatility than others will not have citizens willing to save or invest for the long term. The high inflation and volatility breeds uncertainty in people’s minds and they are more happy to spend today rather than save for tomorrow. They figure that the value of their money is going to down anyway because of the inflation or the next wave of depression so might as well have a good time now.
Internal factors that impact Marginal Propensity to Consume
- Nature of Raise: Last year the US Government issued stimulus checks to people in order to boost incomes, spending and stimulate the economy. This year, instead of stimulus checks, the government reduced the withholding tax and allowed everyone to get a little extra in their pay checks every fortnight. The rationale was that when you give a lump – sum to people, not all of them end up spending it and some save it. But, if you increase the amount they get every month, then that creates a semblance of permanency and people boost their spending to match their new improved income.
- Age: Younger people tend towards spending more than saving. Primarily because they don’t worry as much about retirement as older people do. Younger people generally have lesser responsibilities like children’s education and so there is lesser incentive for them to save than their older counterparts.
- Job Security: People working in sectors such as defense, government or medicine whose prospect of unemployment is low will have a higher marginal propensity to consume than freelancers and others who don’t have a fixed income and see fluctuating incomes from one month to the other.
Keynes wrote about the Marginal Propensity to Consume and here is what he had to say about the factors affecting the Marginal Propensity to Consume:
These eight motives might be called the motives of Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride and Avarice; and we could also draw up a corresponding list of motives to consumption such as Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance.
You can click here to go through a description of the motives, but I thought the names were self explanatory and so didn’t list them out in detail.
Marginal Propensity to Consume is an interesting concept to think about in times where the economy needs spending but the environment is more conducive to saving.
What other factors do you think impact a person’s propensity to spend or save?
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