Relationship between marginal propensity to consume and save

¶ … marginal propensity to consume refers to the proportion of an increase in pay that is spent on the consumption of goods (Investopedia, 2012). The marginal propensity to save is the opposite -- the increase in savings that derives from an increase in pay. The two are opposites because it is assumed that whatever portion of a pay increase is not spent on consumption goes into savings. The two should, when put together, account for an entire pay increase.

The GDP of an economy is a function of consumption, business investment, government spending and net exports. Thus, there is a relationship between the marginal propensities and the GDP. When wages rise, consumers will save some of those wages and spend some. The portion that is spent increases "C," or consumer consumption, causing an increase in GDP.

If somebody wanted to calculate how much of an increase GDP would occur from an increase in wages, this would be the multiplier. Remember that the aggregate wage in an economy is going to be related to business investment or government spending, both of which contain a wage component. For a government trying to boost the GDP, marginal propensity to consume or to save is important. For example, an increase in government spending consists partly of new hiring. These new workers have a given propensity to consume. So $1 million in new government hiring, with workers consuming 95% of that marginal income, will produce $950,000 in new consumption.

That new consumption will give a boost to industrial production, some of which will be in wages, and to imports. Say $300,000 was imports, which pays $30,000 in wages to importers; and $650,000 went to new industrial production, of which $100,000 went to hiring new workers. That implies $130,000 new wages, of which $123,500 will go to consumption. This government spending, therefore, trickles through the economy. The more marginal spending is in the form of consumption, the more of the original money will go directly into growing the GDP. The same is true of new business hiring -- say if the government signs a new free trade deal, providing the opportunity to a factory to expand and sell more to a foreign country.