The Marginal Propensity to Consume (MPC) plays an important role in determining by how much consumption will increase if there is a rise in incomes. It is the proportion of any increase in income that is spent on consumption and is calculated by the formula: ∆C/∆Y, i.e., change in consumption divided by the change in income. The MPC of very low income groups is likely to be 100% as any increase in their incomes, is likely to be spent on essential such as food, clothing and shelter. Even at living standards beyond this, it is likely that the MPC may be high – about 90%. Although it will decline a little as some of the increase in income is saved. However, when income levels are high and there is a general affluence, the MPC falls to 60-70% or so. The rest of the income is saved and adds to wealth.
If incomes increase, the AD will shift to the right. A key way in which consumers may receiver more (or less) personal disposable income (PDI) is by the affects of direct taxation such as income tax and social security contributions. It the government raises income tax, the PDI of consumers falls, consumer spending declines and the AD curve shifts to the left, ceteris paribus.
Consumption is also affected by government policies, which affect the distribution of income. For example, if the government has a policy to re-distribute income from the rich to the poor, overall PDI might stay the same, but the MPC of the lower income groups will be significantly higher than the high income group people. Hence, consumption will increase and the AD curve will shift to the right. The rate of interest is also an important factor in determining consumption. Consumers generally buy goods like consumer durables and housing on loan or credit. If the interest rate is high, the repayments of these consumers will go up and their PDI will reduce. This will reduce consumption and make the AD curve shift to the left, ceteris paribus.
High inflation reduces consumption as households try to protect their savings against the eroding effect of price rises. Asset prices are important as well – a booming stock market or housing market encourages spending, as people feel less cautious because they know they could sell their shares and they borrow money against the rising value of their property. Consumer confidence affects consumption as well. For example, with the prospect of war, people tend to spend less and during a period of low unemployment, people will be willing to spend more.
