The main factors that drive the marginal propensity to consume (MPC) are the availability of credit, taxation levels, and consumer confidence. According to Keynesian economic theory, the propensity to consume can be influenced by government economic policy. Specifically, Keynesian economics theorizes the government can increase consumption levels and the overall robustness of the nation’s economy through interest rate policy, taxation, and redistribution of income.
MPC and MPS
The MPC is a Keynesian concept that refers to the amount of each dollar of additional income consumers tend to spend rather than save. It’s the companion ratio to the marginal propensity to save, the ratio indicating how much of each dollar of additional income consumers tend to save. Basic Keynesian economic theory posits that changes in the percentage of income used for consumption have a multiplier effect on gross domestic product (GDP) because increased spending spurs increased production, which results in higher employment and higher wages. This further increases spending, leading to further increases in production.
Keynesian theory believes levels of consumption can be significantly affected by government economic policy, specifically by interest rate policies, taxation and redistribution of income. According to Keynesian economics, spending is the most important factor driving an economy, and saving by consumers is a drag on the economy, the exact opposite of what any financial advisor would tell a client regarding personal financial health.
Using Interest Rate and Tax Policies to Increase MPC
Keynesian economists believe interest rate policies and tax policies are two major means a government can use to increase the MPC. According to Keynes, it’s important to have a taxation system in place that places the bulk of taxation on richer individuals and the least tax burden on poorer households. This is because poorer segments of the population have a greater need to spend since they, unlike the very rich, have more things they need to acquire, such as houses and cars. Therefore, the extra disposable income made available to lower-income households by tax cuts is more likely to be devoted to consumption rather than to savings.
In addition to tax policy, interest rate policy is also believed to have a significant impact on the MPC, specifically whether credit is readily available or more tightly restricted. Readily available credit and lower interest rates are believed to increase the MPC since this makes it easier for consumers to finance purchases and to obtain financing at attractive rates. Restricted credit can have the opposite effect, increasing the marginal propensity to save since, for example, larger down payments are generally required for major purchases, such as homes or automobiles.
The consumer confidence index (CCI) is considered a leading economic indicator because consumer confidence is also believed to be a driver of consumption, regardless of changes in income level. Basically, if consumers feel confident about their future prospects in terms of income, they tend to spend at greater levels and take on additional debt, believing they can handle the additional financial burdens from increased expenditures.