Marginal Propensity to Save (MPS) is a key concept in economics that helps us understand how changes in income affect household saving behavior. It essentially measures the portion of additional disposable income that households choose to save for the future, rather than spending it on goods and services (aggregate expenditure). Understanding MPS is crucial as it plays a significant role in a country’s investment potential and overall economic growth.
What is the Marginal Propensity to Save?
The Marginal Propensity to Save (MPS) is a concept in economics that sheds light on how households allocate their additional disposable income. It essentially measures the portion of extra money they choose to save rather than spending it on immediate needs or wants. Calculating the MPS involves dividing the change in a household’s savings by the change in their disposable income.
MPS plays a critical role in a country’s economic health because it impacts its potential for investment and growth. Here’s how:
Fueling investment: High MPS translates to a higher national savings rate. These savings essentially become a pool of funds that can be used for investments. Businesses can borrow from this pool to finance expansion, purchase new equipment, or develop innovative products. This investment activity can lead to increased production, job creation, and overall economic growth.
Understanding the multiplier effect: Economists analyze the multiplier effect to understand how changes in spending or saving ripple through the economy. Interestingly, the MPS value inversely affects the multiplier effect.
A lower MPS (meaning a higher portion of income is spent) leads to a larger multiplier effect. This is because increased spending creates a demand for more goods and services, prompting businesses to produce more. This, in turn, requires hiring additional workers, boosting incomes further, and potentially leading to a cycle of increased spending and economic activity.
Formula to calculate the marginal propensity to save
Economists assume that households spend their disposable income in two expenditure categories: savings and consumption. Disposable income is the income left after they pay tax (or after-tax income). So, if they have Rp200 disposable income and spend Rp160 on goods and services, it means the remaining Rp40 is for savings.
In short, the sum of savings and consumption will be equal to consumer income. Likewise, every time receiving extra income, consumers will spend it on consumption and savings.
- Change in disposable income = Change in savings + Change in consumption
Next, what is the marginal tendency to save? It is a portion of the extra disposable income that the household saves. We calculate it by the following formula:
- MPS = Changes in savings/Changes in disposable income
Let’s link the formula above with the concept of marginal propensity to consume (MPC), which is the portion of extra money that households spend on goods and services.
- MPS = (Changes in disposable income – Changes in consumption) /Changes in disposable income) = 1 – (Changes in consumption/Changes in disposable income) = 1- MPC
Take, for example, an individual who earns an additional income of Rp100,000, where Rp80,000 consumers spend on goods and save the rest (Rp20,000). Hence, the MPS value is 0.2, while the MPC value is 0.8 (1-0.2).
How MPS affects the economy
The concept of Marginal Propensity to Save (MPS) goes beyond individual households and plays a significant role in a nation’s economic landscape. Here’s a deeper dive into how high MPS translates to more investment opportunities:
Building the national savings pool
The concept of Marginal Propensity to Save (MPS) goes beyond individual households and plays a significant role in a nation’s economic landscape. When households across a country have a high MPS, it translates to a higher national savings rate. Imagine all these individual acts of saving as tiny streams flowing into a larger reservoir. This reservoir represents the national savings, which essentially becomes a pool of funds available for investment.
The investment engine
These national savings act as fuel for the engine of investment. Businesses can tap into this pool of funds through various channels, such as the capital market. They can borrow money by issuing bonds or taking out loans from banks. With this borrowed money, businesses can finance crucial activities like:
- Expanding production facilities: This allows them to produce more goods and services to meet growing consumer demand.
- Purchasing new equipment: Upgraded technology can improve efficiency and productivity, leading to cost reductions and potentially lower prices for consumers.
- Developing innovative products: Investment in research and development can lead to the creation of new products and services, boosting overall economic activity.
Increased investment due to a high national savings rate can trigger a positive chain reaction known as the multiplier effect. As businesses invest and expand, they often hire more workers. This leads to increased income for these workers, who then have more money to spend on goods and services. This rise in consumer spending further stimulates businesses to produce more, creating a ripple effect of economic growth.
Government borrowing and infrastructure investment
High national savings also benefit governments. Governments can borrow funds from the domestic market by issuing government bonds, which allows them to finance vital infrastructure projects like roads, bridges, and public transportation systems. Improved infrastructure can attract businesses, facilitate the movement of goods and services, and contribute to overall economic development.
The multiplier effect of savings
Keynes views, government stimulus on domestic consumption will lead to a multiplier effect on the economy, which is:
- Multiplier = 1/(1-MPC)
Because 1-MPC is equivalent to MPS, the magnitude of the MPS multiplier effect is as follows:
- Multiplier = 1/MPS
According to the formulas, the higher the MPS, the smaller the multiplier effect. The lower the MPS, the higher the multiplier effect. In short, an increase in MPS does not have a large effect on the economy. Why is that?
The ample supply of funds does not stimulate producers to increase production. While lower interest rates might reduce investment costs, this does not necessarily encourage them to increase output and recruit new workers.
So, in the short run, production will only increase if the business sees enough demand to absorb additional output. If not, it will only create excess supply in the market, depress prices, and squeeze their profit margins.
That contrasts with consumption. Increased consumption reflects higher product demand. Producers are encouraged to increase production because the output is likely to be absorbed by the market. That way, they can generate more revenue.
Producers hire more workers to meet the demand. It results in increased job creation in the economy, leading to a lower unemployment rate. In this condition, households see an improved income, encouraging them to spend more on goods and services. Higher spending stimulates producers to increase output further and hire more workers. The process continues and creates a high multiplier in the economy.
Determinants of Marginal Propensity to Save (MPS)
Understanding what influences a household’s decision to save is crucial when analyzing the Marginal Propensity to Save (MPS). Here’s a breakdown of some key factors that shape MPS:
Disposable income: This is the money left after taxes. As disposable income rises, households generally have more leftovers after covering basic needs. This allows them to potentially save a larger portion of their income, leading to a higher MPS. Conversely, when disposable income falls due to factors like tax hikes or economic downturns, households might prioritize essential spending, potentially lowering their MPS.
Income levels: There’s a general trend where wealthier households tend to have a higher MPS compared to lower-income earners. This is because higher-income individuals might have already met their basic needs and have more financial security, allowing them to allocate a larger portion of their income towards savings and future goals. Lower-income households, on the other hand, often spend a larger share of their income on essential goods and services, potentially resulting in a lower MPS.
Wealth: A household’s overall wealth can also influence their MPS. Wealthier households might have a larger financial cushion, allowing them to save a bigger portion of their current income and potentially have a higher MPS. However, it’s important to remember that this doesn’t always hold true. Some wealthy individuals might still choose to spend a significant portion of their income despite having accumulated wealth.
Interest rates: The interest rate environment can influence saving decisions. When interest rates are high, it can incentivize saving as it offers a potentially higher return on deposited funds. This could lead to households allocating a larger portion of their income towards savings, potentially increasing their MPS. Conversely, when interest rates are low, the incentive to save might be diminished, potentially leading to a lower MPS.
Employment situation: Job security and future income expectations can also play a role in how much households save. If individuals feel secure in their jobs and optimistic about their future income prospects, they might be more comfortable spending a larger portion of their current income. This could lead to a lower MPS in the short term. However, during periods of economic uncertainty or job insecurity, households might prioritize saving for a potential financial buffer, potentially increasing their MPS.
