Marginal Propensity to Save
The marginal propensity to save is the fraction of an additional unit of disposable income that households save rather than consume. It is the counterpart to the marginal propensity to consume, and the two sum to one, since any additional income is either spent or saved. The marginal propensity to save determines how much of an increase in income leaks out of the circular flow of spending, and it therefore governs the size of the multiplier and the effect of changes in income on aggregate demand.
Definition
The marginal propensity to save is the change in saving divided by the change in disposable income that causes it. If a household saves twenty per cent of any increase in income, the marginal propensity to save is two-tenths and the marginal propensity to consume is eight-tenths. The marginal propensity to save is generally larger for high-income households and smaller for low-income households, because poorer households must spend most of any additional income on necessities.
The concept is related to, but distinct from, the average propensity to save, which is total saving divided by total income. The average propensity averages the behaviour of all households and all income levels, while the marginal propensity describes the behaviour at the margin. The two can differ, and the difference matters for predicting how aggregate saving responds to changes in income and to redistribution.
Relationship to the multiplier
The marginal propensity to save determines the size of the multiplier. In the simplest model, the multiplier equals one divided by the marginal propensity to save, so that a higher propensity to save means a smaller multiplier. If households save a large fraction of any increase in income, then an initial increase in spending generates less further spending, and the total effect on output is smaller.
This relationship creates a paradox. Although saving is generally beneficial for growth, because it finances investment, an increase in the desire to save, at a time when the economy has spare capacity, can reduce demand and output, a phenomenon known as the paradox of thrift. The paradox arises because what is rational for an individual household, to save more, may be harmful in the aggregate, if it reduces spending and income without increasing investment.
Determinants
The marginal propensity to save varies with income, wealth, and demographic characteristics. Higher-income households have higher marginal propensities to save, because their consumption needs are more easily satisfied. Wealthier households also save more, and households with uncertain income may save more for precautionary reasons. The life-cycle stage matters: younger and older households tend to save less, while those in middle age save more.
Institutional factors also influence saving. The availability of credit, the design of pension systems, the tax treatment of saving, and the level of social insurance all affect how much households save out of additional income. In economies where public pensions are generous, households may save less for retirement, while in economies where they must provide for themselves, saving is higher. The marginal propensity to save is therefore influenced by policy and by institutions, not only by preferences.
Policy implications
The marginal propensity to save is central to the design of fiscal policy. A tax cut or a transfer directed at households with low marginal propensities to save has a larger effect on consumption and on aggregate demand, because those households spend most of the additional income. Targeting support at such households can therefore raise the multiplier and make fiscal policy more effective, and the distribution of the measure across households is a key consideration.
The concept also informs the analysis of national saving and of the current account. A country with a high marginal propensity to save will tend to have higher national saving for a given level of income, which can finance domestic investment or lend abroad, affecting the current account and the external position. Understanding the determinants of the marginal propensity to save is therefore important for both stabilisation policy and the analysis of external balance.
Distribution and aggregate saving
Because the marginal propensity to save is higher for richer households, the distribution of income affects aggregate saving. A shift of income toward the top of the distribution raises aggregate saving, while a shift toward the bottom lowers it, for a given level of total income. This relationship, sometimes called the Kaldorian saving function, has implications for the effect of redistribution on capital accumulation and for the analysis of growth.
The relationship also has implications for demand. If redistribution toward lower-income households raises consumption, it can support demand in an economy with slack, but it may reduce saving and hence the funds available for investment. The balance between these effects depends on the state of the economy and on the response of investment, and it is central to debates about the effects of inequality on macroeconomic performance.
Saving, growth, and the current account
The marginal propensity to save determines how much of a change in income is saved and therefore how much flows into investment or into net foreign assets. A country with a high propensity to save tends to have a higher saving rate, which can finance domestic investment or be lent abroad, contributing to a current account surplus. A country with a low propensity to save tends to have a lower saving rate, which may require foreign capital to finance investment, contributing to a current account deficit.
The relationship between saving and growth is central to the analysis of development and of external balance. High saving can support capital accumulation and growth, but if investment opportunities are limited, it may result in capital outflows and in the accumulation of foreign assets. Policies that affect the propensity to save, including the design of pension systems and the tax treatment of saving, therefore affect the current account and the external position, as well as domestic investment.
The paradox of thrift
The paradox of thrift describes the possibility that an increase in the desire to save, at a time when the economy has spare capacity, reduces demand and income without increasing aggregate saving. If all households try to save more, they spend less, which reduces income and employment, and the reduction in income may offset the increase in the saving rate, leaving total saving unchanged or even lower. For an individual household, saving more is prudent, but in the aggregate the effect can be harmful.
The paradox is a central theme in Keynesian economics and it informs the analysis of recessions and of the appropriate policy response. It implies that policies encouraging saving can be counterproductive in a downturn, and that measures to support demand may be needed to prevent a fall in income. The paradox also illustrates the importance of distinguishing between the intentions of individual households and the outcome for the economy as a whole, a distinction that is central to macroeconomics.