Consumption and Savings Functions / Spending Multiplier

Focus: the relationship between income and consumption (income vs. saving)

Why do we care about consumption spending?
GDP = C + Ig + G + Xn
 
disposable income 

• Most significant factor in consumption spending
• disposable income = after tax income
• saving = disposable income - consumption
• S = DI - C 
• personal saving = not spending

Assuming room for growth...
More spending = higher GDP
More saving = lower GDP

Average Propensity to consume (APC)

• The average of what people will consume.
• %  or fraction of total income consumed
• APC = Consumption / income

Average propensity to save (APS)

• The average of what people will save.
• % or fraction of total income saved
• APS = savings / income

APC + APS will always = one.

Marginal Analysis
What happens when a new DI is added?

Marginal propensity to consume

• What % of new DI will people consume (spend)
• MPC = change in consumption / change in income

 Marginal propensity to save

• What % of new DI will people save.
• MPS = change in saving / change in income

MPC + MPS will always = one.


Spending Multiplier Effect: a change in 
a component of total spending leads to a 
larger change in GDP.

• any initial change in spending will set off a spending chain throughout the economy 
• diminishes at each step 
• taken together, results in an overall change in GDP

Multiplier = 1/1-MPC
or
Multiplier = 1/MPS 

• the smaller the fraction of any income saved, the greater the multiplier.
• the higher the MPC, the greater the multiplier.