Marginal Propensity to Consume and Your Rebate Checks

by Kevin on April 29, 2008

TV

(Photo by Fleur-Design)

Starting this week, millions of Americans will be receiving tax rebate checks ranging from $600 to over $1,800 depending on how many kids are in your household. The government is hoping that you and I will take those ‘free’ checks, run out to Best Buy, and buy a LCD flat screen television. Today I’ll discuss why the government thinks that is a good idea. Tomorrow I’ll tell you what we’re doing with our check, and show you options of what you can do with yours.

Why does the government want me to spend $1,200?

I’m currently enrolled in an economics class in my MBA program. We discussed the rebate checks during the macro economics portion of the class. I will try not to get too technical and leave things easy to understand. For you economists out there, cut me some slack as this isn’t a lecture!

In an economic sense, any economy’s output runs off of these three things: consumer spending, investment, and government spending. Consumer spending is where you and I spend our hard earned dollars. It is affected by taxes and income (higher taxes or lower income = less spending = less output, and vise versa). Investment isn’t the type of investment you and I discuss regularly. This investment is capital investment. In a business sense, building factories, buying equipment, etc. Government spending is… where the government spends money.

Increasing spending in any way induces varying levels of a multiplier effect, dependent on what the increase was based off of.

For example, imagine the government decides to repave every single interstate in the country. They borrow (or tax) money, and jobs are created. Perhaps a new department is formed, which employs people. Workers are brought in to do the repaving. They earn money, and spend it in the grocery, video game, and hardware store. Those stores employee people, who get to keep their jobs and earn money because of the spending of the repaving workers. They go to the grocery store… etc.

As I mentioned earlier, consumer spending is affected by income and taxes. The rebate checks are essentially a form of lowering taxes by giving money back to the population.

All of this hinges on the marginal propensity to consume…

What is the marginal propensity to consume (mpc)? Essentially it is how much of every discretionary dollar you will go out and spend. If I gave you $100 and you would normally spend $95 of it, your mpc is 0.95. So mpc is on a scale of 0 to 1.

Right now America’s mpc is very high. We are spending more than we are earning and end up with a negative saving rate. Our mpc is very close to 1.

So, the government is trying to boost the economy by giving you and I some extra money. An equal amount of boost could be given by increasing government spending, but tax breaks are far more politically popular. Because our mpc is so high as a country, if most people spend the money then the economy will be given a boost.

That’s a big if…

If America becomes fearful of a recession and instead saves a majority of the tax rebate, it will be a lot less effective. This would bring down mpc (at least for this transaction); the lower it falls, the less boost the economy gets.

So if you want to be a proud American, play along with the government and go spend that check. If that just doesn’t seem right to you, stick around.

Tomorrow I’ll show you how to be a smart American.

{ 7 comments }

Jonathan April 29, 2008 at 10:47 am

Hey Kevin, really interesting post.

Is it possible that America could actually have an mpc of OVER 1, after taking into consideration the massive levels of consumer debt (and as you say, the negative savings rate)?

MyMoneyAdventure April 29, 2008 at 3:09 pm

This story is great, do you mind if I post it on my blog stating it from you?

Thanks!

JB May 1, 2008 at 8:27 am

I have the same question as Jonathan. If we have a negative savings rate wouldn’t the mpc be over 1?

Sim Kaur May 9, 2008 at 2:53 pm

….technically ..the value of MPC ranges from zero to one and the because what we are talking is a change in spending with the change in income ..it can never get above 1

ReneMar June 17, 2008 at 9:54 am

Hello Kevin,
You have a very informative post.
If the MPC is very high meaning Americans are spending higher the they earn. So the lower the MPC the better. Is there anyway that the MPC will become lower?
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Jude Bayham September 22, 2008 at 6:08 pm

I too am a master’s student in economics and I appreciate the disclaimer at the beginning… but, very well described in layman’s terms. To elaborate on Sim Kaur’s point… spending more than your income is not possible. If you are referring to credit… this is considered an income advance, just like saving is postponed consumption…

GS January 30, 2009 at 1:24 pm

“Essentially it is how much of every discretionary dollar you will go out and spend. If I gave you $100 and you would normally spend $95 of it, your mpc is 0.95. So mpc is on a scale of 0 to 1.”

Question: What would the mpc look like for the rich and the poor?

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