Chapter 11: Problem 21

What is the marginal propensity to consume, and how is it related to the marginal propensity to import?

Short Answer

Expert verified

The Marginal Propensity to Consume (MPC) refers to the proportion of additional income spent on consumption, calculated as \(MPC = \frac{dC}{dY}\), where \(C\) represents consumption and \(Y\) represents income. The Marginal Propensity to Import (MPM) reflects the proportion of additional income spent on imported goods and services, calculated as \(MPM = \frac{dM}{dY}\), where \(M\) represents imports and \(Y\) represents income. The relationship between MPC and MPM can be expressed as \(MPC + MPS = 1\), and \(MPM = (1-MPC)*MPW\), with \(MPW\) as the Marginal Propensity to Import on additional domestic spending. This relationship shows that an increase in MPM (spending on imports) leads to a decrease in MPC (spending on domestic goods), and vice versa. Both values are essential for analyzing consumer behavior and designing fiscal and monetary policies.

Step by step solution

Define Marginal Propensity to Consume (MPC)

The Marginal Propensity to Consume (MPC) is an economic term that refers to the proportion of additional income that an individual is willing to spend on consumption rather than saving. It measures a consumer's change in consumption as a result of change in income. Mathematically, it is calculated as the derivative of the consumption function with respect to income: \(MPC = \frac{dC}{dY}\) where: - \(C\) represents consumption, and - \(Y\) represents income.

Define Marginal Propensity to Import (MPM)

The Marginal Propensity to Import (MPM) is an economic term that reflects the proportion of additional income that is spent on imported goods and services in a given economy instead of domestically produced goods and services. In other words, MPM measures the change in the amount of imports as a result of change in income. Mathematically, it is calculated as the derivative of the import function with respect to income: \(MPM = \frac{dM}{dY}\) where: - \(M\) represents imports, and - \(Y\) again represents income.

Understand the Importance of MPC and MPM

Calculating the Marginal Propensities to Consume (MPC) and Import (MPM) is essential for understanding individual and aggregate consumption behaviors in response to changes in income levels. These insights support the design of fiscal and monetary policies that aim to boost consumption, savings, and economic growth.

Derive the Relationship Between MPC and MPM

As both MPC and MPM measure consumer behavior in response to income changes, they are intrinsically related. The sum of marginal propensities to consume and save constitutes the part of income spent domestically. The remaining part of the additional income is spent on imports. Mathematically, we can express the relationship between MPC and MPM as: \(MPC + MPS = 1\) where: - \(MPS\) represents the Marginal Propensity to Save. - \(MPM = (1-MPC)*MPW\) where: - \(MPW\) represents the Marginal Propensity to Import on additional domestic spending (income minus savings). This equation shows that if the additional income (minus savings) spent on Imported goods increases (i.e., MPM rises), the proportion of additional income spent on domestic goods (MPC) will decrease, all other things being equal. In conclusion, the Marginal Propensity to Consume (MPC) represents the portion of additional income spent on consumption, and the Marginal Propensity to Import (MPM) represents the portion of additional income spent on imported goods. Both values are essential for understanding consumer behavior in response to income changes and designing fiscal and monetary policies. The relationship between them shows that if the proportion of additional income spent on imported goods increases, the fraction spent on domestic goods will decrease, and vice versa.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Marginal Propensity to Import

The Marginal Propensity to Import (MPM) is a key concept in understanding how consumers react to changes in their income with respect to their expenditures on goods and services from abroad.

Imagine you receive a bonus at work. If a certain portion of that bonus is spent on purchasing imported products, that portion dictates the MPM for your income increase. If your income increases by \(100 and you spend \)20 on imports, your MPM would be 0.20.
The MPM is not only crucial for personal financial planning but also influences a nation’s balance of trade. A higher MPM signifies that a country is more inclined to purchase foreign goods as incomes rise, which can impact domestic industries and trade deficits. An understanding of MPM helps policymakers in creating strategies to support domestic production and manage international trade relations.

Income-Consumption Relationship

The relationship between income and consumption, known as the income-consumption relationship, is fundamental in consumer economics. This concept explains how consumer spending patterns change as income varies.

Typically, as people earn more, they tend to spend more—not just in quantity but often in quality, upgrading to premium products or services. However, the key point is that people don’t normally spend every extra dollar they earn; they divide the surplus between consumption and savings. This leads to the calculation of the Marginal Propensity to Consume (MPC), which is the portion of each additional dollar of income that is used for consumption.
For example, if a person receives a \(1,000 pay raise and spends \)800 of it, their MPC is 0.8. Understanding this relationship enables economists and policymakers to predict consumer behavior and its impact on the economy.

Fiscal and Monetary Policies

Fiscal and monetary policies are essential tools used by governments to influence a country’s economic conditions. Fiscal policy involves changes in government spending and taxation, while monetary policy deals with the control of the money supply and interest rates by a central bank.

Fiscal policy, such as increasing public spending or cutting taxes, can directly affect the Marginal Propensities to Consume and Import by putting more money into people’s pockets. As a result, MPC and MPM may rise since consumers generally have more income to spend.
Monetary policy can influence consumer behavior indirectly. For example, lowering interest rates typically encourages borrowing and investing, thereby potentially increasing consumption and MPC. Conversely, raising rates may discourage spending and increase savings. Policymakers analyze MPC and MPM in conjunction with these policies to craft strategies that either spur economic growth or cool down inflationary pressures.