Suppose disposable income increases by $2,000. As a result, consumption increases by $1,500. Answer the following questions based on this information. Where appropriate, enter your answer as a decimal rather than as a percentage.
The increase in savings resulting directly from this change in income is:
The marginal propensity to save (MPS) is:
The Correct Answer and Explanation is:
To answer this question, we begin by understanding the relationships among income, consumption, and savings.
Given:
- Increase in disposable income = $2,000
- Increase in consumption = $1,500
Part 1: The increase in savings
Disposable income is divided into consumption and savings. That is: Income=Consumption+Savings\text{Income} = \text{Consumption} + \text{Savings}
So, to find the increase in savings, we subtract the increase in consumption from the increase in income: Increase in savings=$2,000−$1,500=$500\text{Increase in savings} = \$2,000 – \$1,500 = \boxed{\$500}
Part 2: The Marginal Propensity to Save (MPS)
The Marginal Propensity to Save (MPS) measures the proportion of additional income that is saved rather than spent on consumption. It is calculated as: MPS=Change in SavingsChange in Income=5002000=0.25\text{MPS} = \frac{\text{Change in Savings}}{\text{Change in Income}} = \frac{500}{2000} = \boxed{0.25}
Explanation (300+ words):
The concepts of marginal propensity to consume (MPC) and marginal propensity to save (MPS) are foundational in macroeconomics, especially in understanding how changes in income affect the economy. These two metrics represent the fraction of any additional dollar of income that a household will either spend or save.
In this scenario, a household receives an additional $2,000 in disposable income. Of this, $1,500 is used for consumption, meaning the remaining $500 must be saved. This gives us an immediate understanding of how this household allocates new income.
The marginal propensity to consume (MPC) is: MPC=15002000=0.75\text{MPC} = \frac{1500}{2000} = 0.75
Since income can only go to consumption or saving, the sum of MPC and MPS is always equal to 1: MPC+MPS=1⇒0.75+0.25=1\text{MPC} + \text{MPS} = 1 \Rightarrow 0.75 + 0.25 = 1
This makes MPS = 0.25, which means that for every additional dollar the household earns, it saves 25 cents.
Understanding MPS is crucial for policymakers. For instance, a lower MPS implies more spending and higher short-term economic activity. In contrast, a higher MPS means more saving, which might be beneficial for long-term investment but may dampen immediate economic growth.
In sum, the increase in savings from the $2,000 income increase is $500, and the marginal propensity to save is 0.25, reflecting the portion of extra income that is not spent but rather saved for the future.