Marginal Propensity to Save

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Definition of Marginal Propensity to Save:

The marginal propensity to save (MPS) is the proportion of the next dollar received that a consumer would save. For example, if a consumer receives a government check for $100 and saves $30, his marginal propensity to save is 0.30 or 30 percent.

Detailed Explanation:

Economists use the word “margin” to refer to the next. Marginal cost is a supplier’s cost to provide one more unit of a good or service. The marginal propensity to save measures the portion of added disposable income a household would save rather than use to purchase consumer goods. It is calculated using the following formula:

MPS   = Change in Consumer Saving
Change in Disposable Income

What is not saved must be spent, so the marginal propensity to consume equals:

MPC = 1- MPS

Individuals have different marginal propensities to save, and an individual’s marginal propensity to save may change. What factors contribute to your marginal propensity to save?

Income:
Generally, households with a larger income have a higher marginal propensity to save. Higher-income households have satisfied most of their consumer needs and save or invest more. Assume you just graduated from college and are moving into your first apartment. Your salary equals $35,000. You barely earn enough to pay your monthly bills. Your boss gives you a $2,000 bonus. Chances are you will use it to purchase an item you need but do not own. Perhaps you will upgrade your wardrobe. Saving may be less of a concern at this point in your life.

Let’s fast forward 16 years. You have prospered and are well-established. You and your spouse have two children approaching college age. Your combined income is $150,000. Your boss gives you a bonus. There is a good chance you will place a higher percentage of your income in savings since your consumer needs are not as urgent as when you were younger.

Consumer Confidence:
Times are great and your company is thriving. It has just landed a large contract with a company in Romania. You anticipate receiving a large raise soon. Your positive outlook may induce you to purchase a new car, or plan an exotic vacation. 

Now let’s assume that the economy enters a recession. The Romanian company withdraws its contract and you become concerned your company will begin laying off people in your department. It is likely that you will put off buying a new car and perhaps plan a vacation closer to home.

Confidence in the future affects the marginal propensity to save. Households spend more when they feel confident. They save more when they fear the future. 

Short-Term or Permanent Change:
Would you behave differently if you received one big check of $12,000 versus if you received a raise of $1,000 per month? Chances are you may pay down your mortgage or invest in stock with a $12,000 check. These are considered forms of saving since savings is money left over after purchasing consumer goods. 

Would you place $1,000 more in savings each month if you received a $1,000 pay raise? Most people would not. They would indulge a bit. The marginal propensity to save is higher when the added disposable income is received as a lump sum.

Interest Rates or Opportunity Cost:
Consumers normally save or invest more when provided an investment earning a higher return. The opportunity cost of consumer spending is higher. For example, if you received a bonus, would you deposit more in savings if the interest increased from 2 percent to 10 percent? Chances are you would deposit more in savings when the rate is 10 percent. A household’s MPS is higher when interest rates are higher

Fiscal Multiplier Effect

The MPS determines the fiscal policy multiplier, which economists use to estimate how much a tax cut or spending increase will increase the economy’s aggregate demand. An economic stimulus such as a tax cut or spending increase has a greater impact on the aggregate demand when the MPS is lower. More of the stimulus is returning to the economy as consumer spending. The formula for the fiscal multiplier is:

Fiscal Multiplier = 1 / MPS

In 2008, at the beginning of the Great Recession, President George W. Bush attempted to stimulate the economy by providing a rebate. The National Bureau of Economic Research reported, “Of those households receiving the rebate, almost 20 percent reported that they would spend it; nearly 32 percent reported that they would mostly save the rebate, and 48 percent reported that they would mostly pay debt with the rebate." The authors concluded that there was a “low bang for the buck” because the rebate did not stimulate the economy as much as expected. Why? First, the rebate was made when most consumers were fearful of the economy’s direction. Consumer confidence was low, so many used the rebate to pay down debts or deposit it in savings. Second, the rebate was a one-time payment. 

Dig Deeper With These Free Lessons:

Fiscal Policy – Managing An Economy By Taxing and Spending
Monetary Policy – The Power of an Interest Rate
Marginal Analysis – How Decisions Are Made