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# Relationship Between Economic Ratios, Research Paper Example

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Research Paper

Marginal Propensity to Consume

Within the context of Economics, the marginal propensity to consume (MPC) may be defined as an observable measurement that determines consumption. Consumption is a raise in the level of personal spending and this correlates to an increase in the level of disposable income. Hence that share of usable monies the consumer wishes to spend on consumer goods is known as the propensity to consume. This can be expressed in mathematical terms by means of the following formula as illustrated below. (Baumol, W.J. 2010)

 Income Consumption 130 130 190 180

The marginal propensity to consume is determined by the division of a change in consumption by the change in income or MPC=?C/?Y. In consideration of the following table by way of illustration:

Here ?C = 50

?Y = 60

MPC = ?C/?Y = 50/60 = 0.83 or 83%

The Marginal Propensity to Save

This theorem relates to the increase in saving of current goods and services. The term Marginal propensity to Save (MPS) is essentially the savings that are derived from an increase in income or that share of household income that is set aside for saving. It is expressed in mathematical terms as follows: (Shim, J.K. 2005)

 Savings Income 300 1000 600 2000

Using a simple example MPS can be illustrated as follows:

Change in Savings = (600-300)=300

Changes in Income = (2,000-1,000)=1,000

MPS = Change in Savings / Change in income

= (300/1000)= 0.3

Hence for each additional 1 unit of income the savings will increase by 0.3

The MPs is considered an important part of what is known as Keynesian economics as it is an important definition of the saving to income relationship and the opposite side of the consumption to income relation. MPS is also one of the key variables in the determination of the multiplier. This is an important reflection in modern society because the marginal propensity to save is far greater for the more affluent members of society than that of the poorer person. This is best illustrated by considering an equitable increase in income for a rich and poor person. If both were given \$5 increase in income the MPS would be far greater for the rich person than that of the poor person. In sociological terms this has often given rise to the term ‘ the rich get richer and the poor get poorer’.

The Marginal Propensity to Consume (MPC) has a heavy reliance upon inflation adjusted rate of interest. High interest rates attract higher levels of spending. Economists lean towards examination and distinction of the marginal propensity to consume (MPC) between that of permanent and temporary income. This is because consumers expect any changes in the level of income to be permanent and as such this will influence their level and confidence in spending. As such the Keynesian multiplier should be larger where permanent changes of income are indicated. These subtle changes were ignored by the early economists as they found it difficult to find precise determinators that reflected such changes were permanent by nature.

Recession and MPC

There has been some criticism levelled at the current Obama administration in the US concerning the Marginal Propensity to Consume (MPC). It is considered that in the current recessionary environment the average Americans have been at 99% on the MPC line. Translated this means the average American is spending 99% of his or her income that is brought home. Critics state the government is using MPC with tax/stimulus decisions. This means that most average Americans will see little difference in any additional income they earn and this will not be saved but increase consumer spending and thereby stimulate the economy. The reality is that most Americans are using any disposable income to pay down existing debts and this has little effect in terms of stimulating the economy. Even those that are not paying off debt are putting any reserves into a savings account and as such this has little impact on stimulating the economy.

The Multiplier

The multiplier is a factor of proportionality that measures endogenous variable changes. It is related to the marginal propensity to consume as follows, as expressed in mathematical terms: (Baumol, W.J. 2010)

Relationship Between MPC & MPS?

In simplistic terms the relationship between MPC and MPS is one of saving or consumption on each dollar earned. There are essentially two forms of choices available for the average American i.e. save it or spend it. The MPC illustrates the changes in consumption when the income either increases or decreases. The relationship is such that consumption only tends to increase when disposable income increases. On that basis consumption does not rise as quickly as income because not everything that is earned translates as disposable income. Critics have argued that MPC is around 0.99 or 99% of income, in other words we are having to spend everything that we earn in order to maintain status quo. This is not a stimulus to the economy but a reflection of hard times and a recessionary environment.

MPS may be classified as being everything else that is not consumed and as such this increases at a far slower rate than either consumption or income. In mathematical terms MPS + MPC must always be equal to 1. Hence if you are not spending the earned money you must be saving it. In simplistic terms this means if MPC =0.9 then MPS = 0.1 or for every dollar that is earnt you spend 90 cents and save only 10 cents. The dangers of this are fairly apparent. If your income is not enough for you to live on then you may be borrowing additional monies that your current income ration states you cannot pay back. This means you slide into a negative equity position with potentially long term serious consequences. An analogy of this is the mess that Greece has found itself in, within the context of the European debt crisis, it tried to borrow its way out of debt with no viable means or plan to repay the accumulated debt. Ultimately this impacts its’ credit rating and leads it into a default position or situation of bankruptcy.

References

Jae K. Shim, J. G. (2005). Macroeconomics. In J. G. Jae K. Shim, Macroeconomics (pp. 59-60). New York: Barons Educational Series.

William J. Baumol, A. S. (2010). MacroEconomics Principles and Poilicy. Mason OH: Cengage Learning.

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