Propensity to Consume, Marginal

PROPENSITY TO CONSUME FROM WEALTH

BIBLIOGRAPHY

A marginal propensity to consume is, in economics, a change in consumption associated with a change in a factor that determines consumption. The most common use of the term is with respect to income. The concept stems from John Maynard Keynes’s (1883-1946) General Theory of Employment, Interest, and Money (1936), Book III of which is titled “The Propensity to Consume.” Keynes defines the marginal propensity to consume as the change in consumption associated with a change in income (p. 115); later usage has differentiated a number of these propensities.

In elementary Keynesian models of the aggregate economy, the marginal propensity to consume from income determines the expenditure multiplier, the amount that total output will increase from an increase in autonomous spending (Keynes emphasizes this point in the General Theory immediately below his introduction of the term). If the marginal propensity to consume from income is nine-tenths, a one-dollar increase in autonomous spending will induce an initial increase of ninety cents in consumer spending and income; this ninety-cent increase in income will then induce a further increase of eighty-one cents in consumer spending and income, and so on. The sum of the increases in income will be ten dollars, or the product of the one dollar injection of autonomous spending and the inverse of one minus the marginal propensity to consume from income. Models developed since the General Theory have attenuated the value of the multiplier from the very large ones suggested in the early analysis (in full employment models the multiplier will be zero); however, it is still the case that there will be a positive relationship between the multiplier and the marginal propensity to consume from income.

Given the central role of the marginal propensity to consume from income in Keynesian analysis, empirical work on measuring this variable started shortly after the General Theory appeared. Early examination of U.S. data, most notably those compiled by Simon Kuznets (1901-1985), suggested that the marginal propensity to consume from income in the short run was substantially less than in the long run. From the 1940s through the 1960s, three broad models of consumer behavior were proposed to explain this divergence. (1) The relative income hypothesis, proposed by James Duesenberry, argued that consumers are reluctant to change their living standards upon experiencing changes in income. Duesenberry maintained that consumption is partly affected by previous peak levels of income. Hence, the marginal propensity to consume out of income will be lower in the short run than in the long run. (2) The permanent income model of Milton Friedman argued that consumers recognize that a very large portion of income changes will be short-lived, or transitory, and will only change spending for those movements that are viewed to be permanent. In the long run, a higher share of income changes will be permanent. (3) The life-cycle model associated with Franco Modigliani (1918–2003) accepted the logic of the permanent income model but modified it to propose that the aggregate marginal propensity to consume out of permanent income would be affected by the distribution of income changes across age groups.

The distinction between the marginal propensities to consume out of permanent and transitory income became of significant policy interest in the United States in the 1960s and 1970s when a number of explicitly “temporary” changes in income taxes were enacted, and others proposed. Research suggests that the consumer spending impact from the enacted temporary tax changes was smaller than from “permanent” tax changes, in line with the idea that the marginal propensity to consume from transitory income is lower than that from permanent income.

More recent studies have noted the anomaly that the propensity to consume from temporary tax changes, while lower than from permanent changes, is considerably higher than theory would suggest. “Liquidity constraints” (the recognition that many consumers are unable to make the costless borrowing adjustments required for the strict permanent income theory to hold) are one plausible explanation for the high propensity. Other research has emphasized how precautionary saving motives—the need for many households to accumulate financial assets to insure against income losses—can affect the propensity to consume from income changes. The spending of households that need to accumulate precautionary savings will, in general, be more sensitive to purely transitory income changes than theory suggests, thus blurring the distinction between the propensities to consume from permanent and transitory income.

PROPENSITY TO CONSUME FROM WEALTH

The marginal propensity to consume from wealth is the partial derivative of consumer spending with respect to household wealth. The life-cycle model highlights the importance of wealth accumulation for retirement in the household spending and saving decision. This emphasis brought the wealth propensity to prominence. Movements in the value of wealth are, in principle, one-time events that will affect spending through the remainder of a consumer’s life. Hence, the marginal propensity to consume from wealth is much smaller than that from income (less than one-tenth from wealth, seven-tenths or higher from permanent income), but given the enormous magnitude of changes in the value of aggregate wealth, even a small number raises the likelihood that major shifts in aggregate consumption could be generated.

The precise size of the aggregate marginal propensity to consume from wealth has been an active issue in the United States since the middle of the 1990s, given the increase in household wealth relative to income and the very large swings in market values. One line of research has emphasized that typically, a disproportionate share of changes in observed wealth (even some movements in wealth persisting for several years) are likely transitory. In other words, a large share of changes in observed aggregate wealth may not factor into consumer spending because households may not believe they will persist indefinitely. In particular, wealth movements that appear inconsistent with other economic developments, such as changes in income or productivity, could be regarded as transitory. Analysts and forecasters should not be assumed to have any special insight into the permanence of currently observed changes in the value of wealth. It follows that applying any estimate based on past experience of the aggregate marginal propensity to consume from wealth to project the spending impact of an observed movement in wealth may be problematic.

SEE ALSO Absolute Income Hypothesis; Consumption; Economics, Keynesian; Keynes, John Maynard; Multiplier, The; Propensity to Import, Marginal; Propensity to Save, Marginal

BIBLIOGRAPHY

Friedman, Milton. 1957. A Theory of the Consumption Function. Princeton, NJ: Princeton University Press.

Keynes, John Maynard. 1936. The General Theory of Employment Interest and Money. New York: Harcourt, Brace.

Ludvigson, Sydney, and Charles Steindel. 1999. How Important Is the Stock Market Effect on Consumption? Federal Reserve Bank of New York Economic Policy Review 5 (2): 29–51.

Charles Steindel

Any comments or statements in this entry represent the views of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.