Chapter 3 Consumption and Savings

1. CONSUMPTION AND SAVINGS

2. Presented By:
Md. Shaifullar Rabbi
BBA & MBA (Major in THM,FBS,DU)
Coordinator & Lecturer
Dept. of Tourism & Hospitality Management
Daffodil Institute of IT(NU)

3. CONSUMPTION
CONSUMPTION (C) – includes expenditure of
households on food, rent, and medical expenses.
In economics, the use of goods and services by
households. Consumption is distinct from
consumption expenditure, which is the purchase of
goods and services for use by households.
Consumption differs from consumption
expenditure primarily because durable goods, such
as automobiles, generate an expenditure mainly in
the period when they are purchased, but they
generate “consumption services” (for example, an
automobile provides transportation services) until
they are replaced or scrapped.

4. SAVING
SAVINGS (S) – is an income received by a consumer
that that is not spent on the output of firms through
consumption expenditure. It is saved for the future.
Savings, according to Keynesian economics, are what a
person has left over when the cost of his or her
consumer expenditure is subtracted from the amount
of disposable income earned in a given period of time.
For those who are financially prudent, the amount of
money left over after personal expenses have been
met can be positive; for those who tend to rely on
credit and loans to make ends meet, there is no money
left for savings. Savings can be used to
increase income through investing in
different investment vehicles.

5. RELATIONSHIP BETWEEN CONSUMPTION AND SAVINGS
• Income = Consumption + Savings
• The largest part of total spending is consumption.
• C = f (Y)
• If income increases, consumption also increases BUT not as quickly as income.
• S = f (Y)
• If income increases, savings also increase BUT at the higher rate than income.
• Propensity to Consumption (how much income is consumed)
• PC = Consumption / Income
• Marginal Propensity to Consumption (how consumption changes with changing income) MPC =
Change in Consumption / Change in Income
• For example, if a household earns one extra dollar of disposable income, and the marginal propensity
to consume is 0.65, then of that dollar, the family will spend 65 cents and save 35 cents.
• Propensity to Savings (how much income is saved)
• PC = Savings / Income
• Marginal Propensity to Savings (how savings change with changing income)
• MPS = Change in Savings / Change in Income

6. 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:
 Consumption = autonomous consumption + marginal propensity to consume × disposable income.
 A consumption function of this form implies that individuals divide additional income between consumption and
saving.
• We assume autonomous consumption is positive. Households consume something even if their income is zero. If
a household has accumulated a lot of wealth in the past or if a household expects its future income to be larger,
autonomous consumption will be larger. It captures both the past and the future.
• We assume that the marginal propensity to consume is positive. The marginal propensity to consume captures the
present; it tells us how changes in current income lead to changes in current consumption. Consumption increases
as current income increases, and the larger the marginal propensity to consume, the more sensitive current
spending is to current disposable income. The smaller the marginal propensity to consume, the stronger is the
consumption-smoothing effect.
• We also assume that the marginal propensity to consume is less than one. This says that not all additional income
is consumed. When a household receives more income, it consumes some and saves some.

7. MARGINAL PROPENSITY TO CONSUME
The Marginal Propensity to Consume (MPC) refers to how
sensitive consumption in a given economy is to unitized
changes in income levels. MPC as a concept works similarly
to Price Elasticity, where novel insights can be drawn by
looking at the magnitude of change in consumption as a result
of income fluctuations.
Where:
• Change in consumption – Refers to the change in
consumption (of a good, service, or general consumption in
an economy) resulting from changes in income, expressed in
percentage terms.
• Change in income – Refers to the change in income levels of
consumers, expressed in percentage terms.
• MPC is expressed as an absolute value.

8. TYPES OF MPC
1. MPC greater than 1: When we observe an MPC that is greater than one, it means that
changes in income levels lead to proportionately larger changes in the consumption of a
particular good. It can sometimes be correlated to goods with price elasticities of demand that
are greater than 1, as demand for such goods would change by a disproportionately large
factor when prices change. These goods are thought to be non-essential or “luxury goods,” as
demand for these goods is more volatile than demand for essential goods and services.
2. MPC equal to 1: When we observe an MPC that is equal to one, it means that changes in
income levels lead to proportionate changes in the consumption of a particular good. It can
sometimes be correlated to goods with price elasticities of demand that are equal to 1, as
demand for such goods would change in a linear fashion when prices change. These goods
are fairly rare to observe in real-life economies.
3. MPC less than 1: When we observe an MPC that is less than one, it means that changes in
income levels lead to proportionately smaller changes in the consumption of a particular good.
It can sometimes be correlated to goods with price elasticities of demand that are less than 1,
as demand for such goods would change by a disproportionately smaller factor when prices
change. These goods are thought to be essential; as demand for these goods is less volatile
than demand for non-essential goods and services.

9. FACTORS THAT DETERMINE THE MARGINAL
PROPENSITY TO CONSUME
• Income levels. At low-income levels, an increase in income is likely to see a high
marginal propensity to consume; this is because people on low incomes have many
goods/services they need to buy. However, at higher income levels, people tend to
have a greater preference to save because they have most goods they need already.
• Temporary/permanent. If people receive a bonus, then they may be more inclined to
save this temporary rise in income. However, if they gain a permanent increase in
income, they may have greater confidence to spend it.
• Interest rates. A higher interest rate may encourage saving rather than consumption;
however, the effect is fairly limited because higher interest rates also increase income
from saving, reducing the need to save.
• Consumer confidence. If confidence is high, this will encourage people to spend. If
people are pessimistic (e.g. expect unemployment/recession) then they will tend to
delay spending decisions and there will be a low MPC.

10. MARGINAL PROPENSITY TO CONSUME FROM GROSS INCOME
If a worker gains an extra £100, what will be the marginal propensity
to consume on UK goods? There will be three factors (known as
withdrawals) which limit the marginal propensity to consume on
domestic goods:
• Saving – marginal propensity to save (mps)
• Imports – marginal propensity to spend on imports (mpm)
• Tax – the tax burden – income tax, consumption tax (mpt)
These three withdrawals can limit the marginal propensity to
consume.

11. MARGINAL PROPENSITY TO CONSUME AND TAX CUTS
One important issue regarding MPC is the impact of tax cuts.
If the government wished to pursue expansionary fiscal
policy, they may cut the higher rate of income tax (45% on
income over £150,000). However, the mpc is likely to be low
at this income level. However, if the income tax threshold is
increased, there is likely to be a greater economic stimulus
because, at those income levels, the MPC is higher.

12. MARGINAL PROPENSITY TO SAVE

13. MARGINAL PROPENSITY TO CONSUME AND THE MULTIPLIER
• The multiplier effect states that an injection into the circular flow
(e.g. government spending or investment) can lead to a bigger
final increase in real GDP
. This is because the initial injection
leads to knock on effects and further rounds of spending.
• The marginal propensity to consume will determine the size of
the multiplier. The higher the MPC, the greater the multiplier
effect will be. If the marginal propensity to consume is 0, there
will be no multiplier effect.
• The multiplier (k) = 1/1-mpc. For example, if the government
pursues expansionary fiscal policy (higher G) but consumer
confidence is very low, then there will be a high propensity to
save and a low marginal propensity to consume; this will limit
the effectiveness of fiscal policy because the injection will lead to
only limited increases in spending and aggregate demand.

14. THE MULTIPLIER EFFECT
Every time there is an injection of new demand into the circular flow of income there is
likely to be a multiplier effect. This is because an injection of extra income leads to
more spending, which creates more income, and so on. The multiplier effect refers to
the increase in final income arising from any new injection of spending.
The size of the multiplier depends upon household’s marginal decisions to spend,
called the marginal propensity to consume (mpc), or to save, and called the marginal
propensity to save (mps). It is important to remember that when income is spent, this
spending becomes someone else’s income, and so on. Marginal propensities show the
proportion of extra income allocated to particular activities, such
as investment spending by UK firms, saving by households, and spending on imports
from abroad. For example, if 80% of all new income in a given period of time is spent
on UK products, the marginal propensity to consume would be 80/100, which is 0.8.

15. THE MULTIPLIER EFFECT IN AN OPEN ECONOMY
As well as calculating the multiplier in terms of how extra
income gets spent, we can also measure the multiplier in terms
of how much of the extra income goes in savings, and other
withdrawals. A full ‘open’ economy has all sectors, and
therefore, three withdrawals – savings, taxation and imports.
This is indicated by the marginal propensity to save (mps) plus
the extra income going to the government - the marginal tax
rate (mtr) plus the amount going abroad – the marginal
propensity to import (mpm).

16. APPLYING THE ‘MULTIPLIER EFFECT’
The multiplier concept can be used any situation where there is a new
injection into an economy. Examples of such situations include:
• When the government funds building of a new motorway
• When there is an increase in exports abroad
• When there is a reduction in interest rates or tax rates, or when the
exchange rate falls.
The downward or 'reverse' multiplier: A withdrawal of income from the
circular flow will lead to a downward multiplier effect. Therefore,
whenever there is an increased withdrawal, such as a rise in savings,
import spending or taxation, there is a potential downward multiplier
effect on the rest of the economy.