Marginal Propensity to Consume
The marginal propensity to consume (MPC) is the fraction of an additional unit of disposable income that households spend on consumption rather than saving. It is a central parameter in Keynesian economics and in the analysis of the multiplier. The marginal propensity to save (MPS) is the complement of the MPC, so that MPC plus MPS equals one, in a simple model without taxes or imports.
Definition and measurement
The MPC is defined as the change in consumption divided by the change in disposable income. It differs from the average propensity to consume, which is total consumption divided by total disposable income. The MPC is typically between zero and one, meaning that households spend part of any additional income and save the rest. For very low-income households, the MPC may approach or even exceed one if they borrow to finance consumption.
The MPC is estimated using household survey data, aggregate time-series data, and natural experiments such as tax rebates and lottery winnings. Estimates vary across households and over time, with lower-income and liquidity-constrained households typically exhibiting higher MPCs than wealthier households.
Determinants
Several factors influence the MPC. Income and wealth matter: poorer households consume a larger share of additional income because they have unmet needs and limited access to credit. Uncertainty raises precautionary saving and lowers the MPC. Interest rates affect the incentive to save. Age and life-cycle stage influence consumption and saving behaviour. Expectations about future income, including the permanence of an income change, strongly affect the MPC, since permanent income changes are consumed to a greater extent than temporary ones.
The permanent income hypothesis and the life-cycle hypothesis emphasise that consumption depends on lifetime resources, not just current income. Under these theories, the MPC out of temporary income changes is small, because households smooth consumption. Empirical evidence supports partial consumption smoothing, with significant but not complete offsets.
Role in the multiplier
The MPC is a key determinant of the Keynesian multiplier, which equals one divided by the MPS in a simple closed economy. A higher MPC means that each round of spending generates more subsequent spending, producing a larger multiplier. When taxes and imports are included, the multiplier is reduced, and the relevant parameter becomes the marginal propensity to consume domestic goods out of national income.
The MPC also affects the effectiveness of fiscal policy. Transfers and tax cuts directed at households with high MPCs have larger effects on aggregate demand than measures directed at households that save the additional income. This insight informs the design of stimulus measures and the targeting of support during downturns.
Policy and empirical relevance
The MPC is central to the analysis of tax rebates, stimulus payments, and transfer programmes. Empirical studies of tax rebates in several countries have found that a substantial share of the payments is spent within a few months, with MPCs ranging widely across households. These estimates are used to calibrate the expected effect of fiscal measures on output.
The MPC also matters for monetary policy transmission, because it shapes how households respond to changes in interest rates and wealth. Understanding heterogeneity in the MPC across the income and wealth distribution has become an important area of research, with implications for the design of policy to support consumption and for the distributional effects of macroeconomic shocks.
The MPC over the life cycle
The life-cycle hypothesis, developed by Franco Modigliani, holds that individuals plan consumption and saving over their lifetimes, borrowing when young, saving during middle age, and dissaving in retirement. Under this hypothesis, the MPC out of a temporary income change is small, because individuals smooth consumption by adjusting saving. The MPC out of a permanent change is larger, because it affects lifetime resources.
The permanent income hypothesis, associated with Milton Friedman, makes a similar point, distinguishing transitory from permanent income. Empirical tests have found that consumption is more sensitive to current income than the pure versions of these theories predict, a phenomenon attributed to liquidity constraints, precautionary saving, and myopia. These departures from the benchmark explain why fiscal stimuli can be effective and why the MPC matters for policy.
Heterogeneity in the MPC
The MPC varies across households. Liquidity-constrained households, which cannot borrow against future income, have high MPCs and account for a large share of the aggregate consumption response to income changes. Wealthy households, by contrast, tend to have low MPCs because their consumption is less sensitive to current income. Households with high debt burdens may use additional income to deleverage rather than to consume.
This heterogeneity has implications for policy. Interventions targeted at liquidity-constrained households, such as transfers or refundable tax credits, have larger stimulus effects than broad-based measures. The distributional consequences also differ, and policymakers may consider both the effectiveness and the equity of alternative measures.
The MPC and monetary policy
The MPC affects the transmission of monetary policy. Lower interest rates reduce the cost of borrowing and increase the value of assets, raising consumption. The strength of this effect depends on the MPC out of wealth and on the distribution of wealth and debt across households. Households with high debt burdens may reduce consumption when rates rise, amplifying the effect, while households with large financial assets may increase consumption when rates fall.
Understanding these channels requires household-level data and models that capture heterogeneity. Recent research has used administrative and survey data to estimate the distributional effects of monetary policy, informing debates about the appropriate stance and about the distributional consequences of policy choices.