Marginal propensity to save (MPS) is defined as a portion of the additional income that households save. We calculate it by dividing the change in savings to the change in disposable income.
Formula for marginal propensity to save
Before going into detail, let’s review the basics.
Economists assume that households spend their disposable income into 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 of disposable income, and spend Rp160 into goods and services, it means the remaining of 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 savings. 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 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 the marginal propensity to save affects the economic multiplier?
In macroeconomics, MPS is an indicator of a country’s investment capacity. Household savings contribute to national savings, a representation of the domestic supply of loanable funds in the economy. High savings means that the country has a lot of money to use for investment.
Therefore, the higher the MPS value means, the greater the potential supply of funds. Companies can borrow funds (through the capital market) to buy capital goods and increase their production capacity. Likewise, the government can borrow them through the issuance of debt securities to finance infrastructure.
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
From the formulas, the higher the MPS, the smaller the multiplier effect. And, 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?
Because the ample supply of funds does not stimulate producers to increase production. That might make interest rates lower, reducing investment costs. However, that 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 on the economy.
Disposable income is the key determinant of MPS. And, MPS values tend to vary between income groups. Some wealthy households might spend more on savings (high MPS) than those with low incomes, who spend more on goods and services (high MPC).
Furthermore, other influencing factors of MPS are wealth, interest rates, and employment situations.