Average propensity to consume and save

Aggregate demand analysis explores how people in an economy tend to either spend or save their income. Spending keeps money moving through the economy, supporting further income and activity, while saving removes money from this flow, reducing immediate circulation.

Average propensity to consume (APC)

The average propensity to consume (APC) measures the share of total income that goes towards spending on goods and services.

$\text{APC}=\frac{\text{consumption}}{\text{total income}}$

Where:

• Consumption = Total spending on goods and services
• Total income = Overall income in the economy

Average propensity to save (APS)

The average propensity to save (APS) measures the share of total income that is set aside as savings.

$\text{APS}=\frac{\text{amount saved}}{\text{total income}}$

Where:

• Amount saved = Total savings
• Total income = Overall income in the economy

Marginal propensity to consume and save

Marginal propensities focus on how changes in income affect spending and saving decisions.

Marginal propensity to consume (MPC)

The marginal propensity to consume (MPC) shows the proportion of any additional income that is used for spending.

$\text{MPC}=\frac{\text{change in consumption}}{\text{change in income}}$

Marginal propensity to save (MPS)

The marginal propensity to save (MPS) shows the proportion of any additional income that is saved rather than spent.

$\text{MPS}=\frac{\text{change in saving}}{\text{change in income}}$

Significance in economic analysis

• Impact on multiplier - Marginal propensities are often more useful than average ones for predicting economic changes. A higher MPC leads to a stronger multiplier effect because more extra income is spent, creating further rounds of activity.
• Income level variations - People with lower incomes usually have a higher MPC, as they spend most extra money on essentials. Less developed economies also tend to have higher MPCs, resulting in larger multipliers.
• Savings behaviour - A high MPS means more extra income is saved, which reduces the multiplier as less money re-enters the economy through spending.

Calculating the multiplier effect using MPC

The multiplier effect explains how an initial injection of money into the economy (such as government spending) leads to a greater overall increase in national income. It depends on how much of that extra income is spent rather than saved, with spending creating further income for others.

Formula for the multiplier

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

Where:

• MPC = Marginal propensity to consume

A higher MPC results in a larger multiplier, as more money stays in circulation through repeated spending.

Worked example - Calculating the multiplier using MPC

An economy receives an injection of £120 million. If every extra £1 of income results in 75p being spent on goods and services within the country, calculate the MPC, the multiplier, and the total increase in national income.

Step 1: Identify the values

• Change in consumption per £1 = £0.75
• Injection = £120 million

Step 2: Determine the MPC

$\text{MPC}=\frac{\text{change in consumption}}{\text{change in income}}$

$\text{MPC}=\frac{0.75}{1}=0.75$

Step 3: Calculate the multiplier

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

$\text{Multiplier}=\frac{1}{1-0.75}$

$\text{Multiplier}=\frac{1}{0.25}=4$

Step 4: Calculate total increase in national income

Total increase = injection × multiplier

Total increase = £120 million × 4 = £480 million

Factors influencing the size of the multiplier

The multiplier's size varies based on economic conditions and behaviours, affecting how strongly an injection boosts national income.

Key influences on multiplier size

• Level of MPC - A higher MPC increases the multiplier, as more extra income is spent, leading to greater circulation and economic activity.
• Income levels - Lower-income groups or less developed economies often have higher MPCs, making the multiplier larger because additional income is more likely to be spent on necessities rather than saved.