Marginal And Average Propensity To Consume Pdf

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Propensity to save , in economics, the proportion of total income or of an increase in income that consumers save rather than spend on goods and services. The average propensity to save equals the ratio of total saving to total income; the marginal propensity to save equals the ratio of a change in saving to a change in income.

Average propensity to consume

Policymakers often consider temporarily redistributing income from rich to poor households to stimulate the economy. This is based in part on the idea that poor households spend a larger share of their income than rich ones do. However, ample evidence suggests that the difference in spending between these groups is significantly smaller than commonly assumed.

A second assumption is that redistribution through policy is more efficient than through capital markets. Whether this is true is important to consider when proposing this type of stimulus policy. The idea of taking from the rich and giving to the poor goes back long before the legend of Robin Hood.

This kind of redistribution sounds desirable out of a sense of fairness. However, economists often judge a policy less on whether it is fair, and more in terms of whether it is efficient or inefficient, as well as whether it stimulates or slows economic activity.

In this Economic Letter we evaluate the stimulative effect of redistributing income from rich to poor households in a few distinct steps. We first provide a simple back-of-the-envelope calculation of the potential stimulus from redistributive policies. We then review the two main assumptions behind this policy prescription.

We argue that the stimulative impact of such policies is likely to be lower than the simple calculation suggests. The starting point for our simple estimate is the Consumer Expenditure Survey, which gives an annual picture of complete consumption patterns for U. The solid black line in Figure 1 plots the share of income that households consumed in Spending is then averaged for each decile of the income distribution. The shaded areas below the solid line reflect the share of income spent on different major expenditure categories.

Note: Average as a percent of after-tax income. The figure suggests that households at the lower end of the income distribution spend more than twice what they make. At the upper end, households spend about two-thirds of what they make.

The average propensity to consume shown by the solid black line in Figure 1 is the percent of total income that goes to consumption. However, the percentage of any additional income that goes to consumption is called the marginal propensity to consume. Households may choose to consume less of their additional income than they do of their regular income.

This has policy implications because the effectiveness of redistribution policies is determined by the marginal rather than the average propensity to consume.

In principle we could use the estimated consumption profile in Figure 1 to account for the difference between average and marginal propensities to consume. In practice, however, the difference between the marginal and average propensities to consume does not affect the main conclusion of the initial back-of-the-envelope result. There are still two main reasons why this result overstates the stimulative effect of redistributing income. A closer look at the data in Figure 1 suggests that actual differences in average propensities to consume across households may be much smaller than the figure suggests.

Measurement errors in the levels of consumption and income across the household income distribution are likely to have overstated the difference in propensities to consume.

Standard economic theory Friedman suggests that if households can borrow and save, they will smooth their consumption over their lifetime. This means that their level of spending is determined by the total income over their lifetime, also called permanent income, rather than by their income on a period-by-period basis.

Thus, part of the high reported rates of spending for low-income households in the data may reflect households that faced a temporary reduction in income, for example because of a spell of unemployment or self-employment business losses, or because households expected their income to otherwise significantly increase in the future. For such households, if current income falls substantially below their permanent income, they may end up borrowing money and spending a lot more than they make in a given year.

Moreover, such households may not change their spending a lot if they receive a temporary redistribution through fiscal policy, since it would only slightly increase their permanent income. However, research by Johnson, Parker, and Souleles finds that there is a substantial fraction of households, especially with low liquid wealth and low income, whose behavior is not consistent with the permanent income hypothesis.

Such households actually do adjust their spending quite a bit more than predicted by the theory, even in response to a temporary uptick in their income. Another measurement issue that may explain the observed high spending rates of households in the bottom of the income distribution is that they may understate their actual income. This could result from underreporting government transfer payments, as documented in Meyer, Mok, and Sullivan , or other sources of income. There is a simple way to see whether this might be the case.

By definition, income equals consumption plus savings. In addition to the consumption and income data we used to calculate the propensity to consume in Figure 1, the Consumer Expenditure Survey also contains data on household savings. One can calculate an alternative measure of propensity to consume using the sum of consumption and saving as the measure of income rather than the income reported in the survey.

The resulting alternative profile of the propensity to consume across the household income distribution is shown by the dashed black line in Figure 1. This alternative measure results in a flatter profile of the propensity to consume than the conventional measure, largely because the estimates for low-income households are much lower. The revised estimates suggest these households report consumption and savings levels that are consistent with a substantially higher income than they report in the survey.

At the other end of the distribution, high-income households tend to underreport their consumption, especially for basic items like food. This results in an understatement of their propensity to consume Aguiar and Bils Combining the measurement biases at the lower and upper ends of the income distribution suggests that the actual profile is much flatter than the initial one we discussed. According to the dashed line, the difference in average propensity to consume between poor and rich households appears closer to 30 percentage points rather than the plus percentage points implied by the solid black line.

Our discussion of the permanent income hypothesis touched on the importance of access to credit for household consumption levels relative to income. If households have access to credit then they are able to smooth their spending in response to a temporary negative shock to income. Even if they do not have access to credit, households can still self-insure by setting aside savings to cover expenses in times of unexpected income losses.

The fact that households at the low end of the income distribution can consume substantially more than they earn may also suggest that they have more access to credit than is apparent. In this case, the simple back-of-the-envelope calculation may overstate what fraction of additional income these households would consume.

For redistributive policies to have a stimulative effect, the bulk of households on the receiving end must have limited access to credit and limited savings to cover their spending in case of a loss of income. McKay and Reis study a formal model that includes redistributive policies as an automatic stabilization tool to provide stimulus during economic downturns.

They find that, in general, monetary policy is the preferred stabilization tool. However, when monetary policy is constrained, as it was during the most recent recession, redistributive policies could have a noticeable stimulative impact. Finally, it is important to realize that we have discussed stimulative policy in terms of a temporary redistribution. More permanent shifts in redistribution of income will have a substantial impact on the relative labor supplies of low- and high-wage workers, on the incentives to save, and on expected permanent income levels.

All of these influence how policy might affect the overall economy and are not part of our simple calculation here. Surveys show low-income households tend to spend a larger share of their income than high-income households.

Because of this, temporarily redistributing income from the rich to the poor could stimulate consumption and, through that, the economy as a whole. However, there is evidence that differences in propensities to consume this additional income across households are smaller than commonly assumed.

Moreover, capital markets provide the opportunity for lower-income households to smooth their consumption and maintain it at an acceptable level even when their incomes decline, thereby providing an alternative source of economic stimulus. Thus, how stimulative a redistributive policy is depends crucially on how effective and efficient redistributing through policy is compared with the opportunities already available in financial markets. Alexander Nussbacher is an economics and statistics undergraduate student at the University of California at Berkeley.

Aguiar, Mark A. Friedman, Milton. A Theory of the Consumption Function. Johnson, David S. Parker, and Nicholas S. McKay, Alisdair, and Ricardo Reis. Business Cycle. Meyer, Bruce D. Mok, and James X. This publication is edited by Anita Todd. Permission to reprint must be obtained in writing.

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Propensity to save

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Average Propensity to Consume and Marginal Propensity to Consume

The consumption function is a relationship between current disposable income and current consumption. It is intended as a simple description of household behavior that captures the idea of consumption smoothing. We typically suppose the consumption function is upward-sloping but has a slope less than one. So as disposable income increases, consumption also increases but not as much. More specifically, we frequently assume that consumption is related to disposable income through the following relationship:.

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Policymakers often consider temporarily redistributing income from rich to poor households to stimulate the economy. This is based in part on the idea that poor households spend a larger share of their income than rich ones do. However, ample evidence suggests that the difference in spending between these groups is significantly smaller than commonly assumed. A second assumption is that redistribution through policy is more efficient than through capital markets. Whether this is true is important to consider when proposing this type of stimulus policy.

Reviewed: November 9th Published: February 1st This chapter deals with the question whether there is a relationship between the marginal propensity to consume and the status of the household in income distribution represented by a relative income. If so, then the current assumption of mainstream theory of consumption about the constant marginal propensity to consume could no longer be considered realistic and it will be necessary to take the element of relative income as a new key determinant of general consumption function.

The Propensity to Consume and the Multiplier

Average propensity to consume refers to the ratio of consumption expenditure to the corresponding level of income. In Table 7. APC falls to 1 when income rises to Rs crores. The value of APC further falls to 0. In Fig 7.

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The average propensity to consume is the fraction of the their total income that consumers are spending. Remember marginal propensity to consume is how much you spend out of each additional dollar. But the average propensity to consume is your total overall spending as a fraction of your total overall income.


From the time of Smith and Ricardo the classical school tends to view consumption in a negative light, even though it is by far the largest aggregate in total economic activity. From the classical perspective consumption spending is unproductive, acting as a fetter on the amount a community saves and invests, thereby retarding long-term economic growth. Keynes is the first mainstream economist to treat consumption spending as an ultimate independent variable.

The Keynesian consumption function expresses the level of consumer spending depending on three factors. This suggests consumption is primarily determined by the level of disposable income Yd. Higher Yd leads to higher consumer spending. This model suggests that as income rises, consumer spending will rise. However, spending will increase at a lower rate than income.

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  1. Annett T. 12.06.2021 at 06:14

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