Unit III: Consumption and Saving

Disposable income (DI) is income after taxes or net income. With disposable income, households have two choices. They can:

• Consume (spend money on goods and services)
• Save (not spend money on goods and services)

Consumption (C) is household spending. Households consume if DI = 0 through autonomous consumption and dissaving. The ability to consume is constrained by:

• The amount of DI
• The propensity to save

Saving (S) is when the household is NOT spending. Households do NOT save if DI = 0. The ability to save is constrained by:

• The amount of DI
• The propensity to consume

Here are some formulas and information about average propensity to consume (APC) and average propensity to save (APS):

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 (dissaving)
• -APS (dissaving)

The marginal propensity to consume (MPC) is the percentage of every extra dollar earned that is spent. It is also the fraction of any change in DI that is consumed. Its equations are as follows:

• MPC = (change in consumption)/(change in DI) = ΔC/ΔDI
• MPC = 1 - MPS

The marginal propensity to save (MPC) is the percentage of every extra dollar earned that is saved. It is also the fraction of any change in DI that is saved. Its equations are as follows:

• MPS = (change in savings)/(change in DI) = ΔS/ΔDI
• MPS = 1 - MPC

The spending multiplier effect is when an initial change in spending (C, I, G, and/or X) causes a larger change in aggregate spending, or aggregate demand (AD). This happens because expenditures and income flow continuously which sets off a spending increase in the economy. The equation is as follows:

Multiplier = (change in AD)/(change in spending) = ΔAD/ΔC, ΔI, ΔG, or ΔX

The spending multiplier can be calculated from the MPC or the MPS. Multipliers are positive when there is an increase in spending and negative when there is a decrease. The equation is as follows:

Spending Multiplier = (1)/(1 - MPC) = (1)/(MPS)

When the government taxes, the multiplier works in reverse because now money is leaving the circular flow. If there is a tax cut, then the multiplier is positive, because there is now more money in the circular flow. The equation is as follows (note that it's always negative):

Tax Multiplier = (-MPC)/(1 - MPC) = (-MPC)/(MPS)

For more information, please refer to these videos on Khan Academy:

MPC and multiplier: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/multipliers-ap/v/mpc-and-multiplier?modal=1

Tax multiplier, MPC, and MPS: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/multipliers-ap/v/tax-multiplier-mpc-and-mps-ap-macroeconomics-khan-academy?modal=1