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The standard formula for calculating the marginal propensity to consume, or MPC, is marginal consumption divided by marginal income. This is sometimes expressed as
MPC=mYmCwhere:mC=Marginal consumptionmY=Marginal income
In layman’s terminology, this means MPC is equal to the percentage of new income spent on consumption rather than saved.
For example, if Tom receives $1 in new disposable income and spends 75 cents, his MPC is 0.75 or 75%. If all new income is either spent or saved, Tom must therefore also have a marginal propensity to save, or MPS, of 0.25 or 25%.
Origins of Marginal Propensity to Consume
Famed British economist John Maynard Keynes formally introduced the concept of the MPC in his “The General Theory of Employment, Interest, and Money” in 1936. Keynes argued that all new income must either be spent, as with consumption, or invested, as with savings.
During the depression of the 1930s Keynes understood that the classical thinking where supply would create its own demand does not always work. He noted that in the Great Depression the main problem was a lack of aggregate demand. He also noted that the government spending could add to aggregate demand and that this fiscal stimulus would create a “multiplier effect” through increases in consumer demand. To summarize these concepts, we note that a simple closed economy that aggregates demand can be represented as the following expression:
Y=C+I+Gwhere:Y=Aggregate demandC=Consumer demandI=Investment demandG=Government demand
Keynes also introduced the concept of the consumption function:
C=mY
Where m= the marginal propensity to consume (MPC) with m<1 and for purposes of this discussion we will assume is estimated at .75 indicating that when consumers receive additional income, they spend 75% and save 25%. Investment demand was primary determined by entrepreneurial spirits, interest rates (monetary policy) and current business conditions while government demand was determined by the fiscal decisions made by government.
In this framework we can express aggregate demand as:
Y=C+I+G=mY+I+G
Solving this expression for Y results in:
Y=(I+G)/(1-m)
Where the term 1/(1-m) is the Keynesian income “multipler.” In our example with m=.75 the multipler is
1/(1-.75)=4
If Y falls due to a problem with Investment spending (i.e., business confidence) then the government can step in to increase aggregate demand by increasing G. If m=.75 then the multiplier is 4 indicating a 1 dollar increase in G, all other things being equal would result is an increase in income of 4 dollars in Y.
This was the contribution Keynes made to the economic thinking of the time and was fundamental then, and now, in the role of fiscal policy in getting the economy back to full employment.
In terms of significance, there might not be a more underappreciated part of Keynes’ theory than MPC. This is because Keynes’ famous investment multiplier assumes that MPC has a strict positive correlation with the increased level of investment activity.
Despite the relative simplicity of Keynes’ argument about identifying MPC, macroeconomists have not been able to develop a universally accepted method of measuring MPC in the real economy. Much of the problem is that new income is considered a cause and an effect on the relationship between consumption, investment and new economic activity, which generates new income.