average and marginal propensities to consume (apc and mpc)

National Income, the Circular Flow and Consumption Behaviour (APC & MPC)

1. National‑income aggregates (Syllabus 4.1)

Aggregate	Definition – basic prices	Definition – market prices
GDP (Gross Domestic Product)	Value of all final goods and services produced within the country’s borders.	GDP + taxes on products − subsidies on products.
GNI (Gross National Income)	GDP + net primary income from abroad (factor income earned by residents abroad minus factor income earned by non‑residents domestically).	GNI + taxes on products − subsidies on products.
NNI (Net National Income)	GNI − depreciation of fixed capital.	Same as basic‑price definition (depreciation is a real concept, not price‑related).

Nominal vs. real values – Nominal values are measured at current (money) prices. Real values are adjusted for inflation, usually with the CPI (Consumer Price Index) or a GDP deflator, so that only quantities change.

2. The circular flow of income (Syllabus 4.2)

2.1 Closed two‑sector model (Households ↔ Firms)

• Factor market: Households supply labour, land and capital and receive factor incomes – wages (W), rent (R), profit (Π).
• Product market: Firms sell output and receive revenue. Households use their disposable income Y_d to buy consumption goods C. The residual is saving S.
• Identity: Y = C + S (where Y = national income = total factor income).

2.2 Open‑economy extension (Government & Foreign sector)

• Government: collects taxes T, makes transfers, and spends G.
• Foreign sector: exports X and imports M.
• Leakages: L = S + T + M
• Injections: I_t = I + G + X (where I = private investment).
• Equilibrium condition: L = I_t or S + T + M = I + G + X.

3. Aggregate demand and supply (Syllabus 4.3 – 4.6)

3.1 Aggregate demand (AD)

\[ Y = C + I + G + (X - M) \]

• C = consumption – a function of disposable income Y_d (see §4).
• I = investment – inversely related to the interest rate and dependent on business expectations.
• G = government expenditure – autonomous.
• (X‑M) = net exports – depends on exchange rates and world income.

3.2 Short‑run aggregate supply (SRAS) and long‑run aggregate supply (LRAS)

• SRAS – upward‑sloping; output depends on the price level, input costs and short‑run expectations.
• LRAS – vertical at the economy’s potential (full‑employment) output, determined by real resources and technology.
• Equilibrium in the AD–AS model occurs where the AD curve intersects the SRAS curve. A shift in AD or SRAS creates a new equilibrium (disequilibrium is temporary).

3.3 Price stability & inflation (Syllabus 4.6)

• Inflation = sustained increase in the general price level, measured by the CPI.
• Deflation = sustained fall in the price level.
• Policy aim: keep inflation low and stable (often 2 % ± 1 % in Cambridge examinations).

4. Consumption behaviour: APC and MPC (Syllabus 4.2 & 5.1)

4.1 Definitions

• Average propensity to consume (APC) – the share of disposable income that is spent on consumption. \[ \text{APC} = \frac{C}{Y_{d}} \]
• Average propensity to save (APS) – the share of disposable income that is saved. \[ \text{APS} = \frac{S}{Y_{d}} = 1 - \text{APC} \]
• Marginal propensity to consume (MPC) – the extra consumption generated by a one‑unit increase in disposable income. \[ \text{MPC} = \frac{\Delta C}{\Delta Y_{d}} \]
• Marginal propensity to save (MPS) – the extra saving generated by a one‑unit increase in disposable income. \[ \text{MPS} = \frac{\Delta S}{\Delta Y_{d}} = 1 - \text{MPC} \]

4.2 Typical patterns

• APC falls as income rises because a larger proportion of income is needed for basic necessities.
• MPC is relatively stable in the short run (often 0.5 – 0.9). It is the key determinant of the fiscal multiplier.

4.3 Derivation of the fiscal multiplier (AO2 – calculation not required but useful)

Starting from the equilibrium condition in a closed economy with government:

\[ Y = C + I + G \qquad\text{with}\qquad C = C_{0} + \text{MPC}\,Y_{d},\; Y_{d}=Y-T \] Substituting: \[ Y = C_{0} + \text{MPC}(Y-T) + I + G \] Re‑arranging: \[ Y - \text{MPC}\,Y = C_{0} - \text{MPC}\,T + I + G \] \[ Y(1-\text{MPC}) = C_{0} - \text{MPC}\,T + I + G \] \[ \boxed{\displaystyle Y = \frac{1}{1-\text{MPC}}\,(C_{0} - \text{MPC}\,T + I + G)} \] The term \(\displaystyle \frac{1}{1-\text{MPC}}\) is the **fiscal multiplier**. A higher MPC → larger multiplier → a given change in autonomous spending (e.g., a tax cut) produces a larger change in output.

4.4 Numerical illustration

Disposable income \(Y_{d}\)	Consumption \(C\)	APC \(=C/Y_{d}\)	Δ\(Y_{d}\)	Δ\(C\)	MPC \(=ΔC/ΔY_{d}\)
£1 000	£800	0.80	+£500	+£375	0.75
£1 500	£1 125	0.75
£2 000	£1 500	0.75

APC falls from 0.80 to 0.75 as income rises, while MPC stays at 0.75 – each extra £1 of disposable income generates £0.75 of additional consumption.

5. Economic growth (Syllabus 4.5)

• Definition: a sustained increase in real GDP (or real GNI) over time.
• Growth rate: \[ g = \frac{Y_{t} - Y_{t-1}}{Y_{t-1}}\times 100\% \]
• Sources of growth:
  • Increase in factor inputs – labour, capital, land.
  • Improvement in productivity – technological progress, better organisation, economies of scale.
  • Human‑capital development – education, health, training.
• Nominal vs. real growth – nominal growth includes price changes; real growth reflects only quantity changes (CPI‑adjusted).
• Long‑run growth is represented by a rightward shift of the LRAS curve.

6. Unemployment (Syllabus 4.5)

• Unemployment rate: \[ U = \frac{\text{Number of unemployed}}{\text{Labour force}}\times 100\% \]
• Types of unemployment:
  • Frictional – short‑term job search.
  • Structural – mismatch between workers’ skills and job requirements.
  • Cyclical – caused by insufficient aggregate demand (AD below potential output).
  • Seasonal – regular fluctuations in certain industries.
• Natural rate of unemployment = frictional + structural. The economy is at full employment when actual unemployment equals the natural rate.
• Hysteresis – prolonged high unemployment can raise the natural rate by eroding skills.
• Policy aim: keep cyclical unemployment low without increasing the natural rate.

7. Policy instruments (Syllabus 5.1 – 5.4)

7.1 Fiscal policy

• Changes in G (government spending) or T (taxes) directly affect disposable income Y_d and therefore consumption via the MPC.
• Multiplier effect: \(\displaystyle \Delta Y = \frac{1}{1-\text{MPC}} \times \Delta G\) (or \(-\frac{\text{MPC}}{1-\text{MPC}} \times \Delta T\)).
• Automatic stabilisers – tax receipts fall and welfare payments rise when income falls, partially offsetting the drop in AD (size linked to APS).

7.2 Monetary policy

• Central bank controls the policy interest rate (e.g., Bank of England base rate).
• Lower rates → cheaper borrowing → higher investment I and, via wealth effects, higher consumption C.
• Quantitative easing (QE) – purchases of government bonds to increase the money supply and lower long‑term rates.

7.3 Supply‑side (structural) policy

• Improves LRAS by increasing productivity: investment in infrastructure, education, research & development, deregulation, tax incentives for firms.
• Reduces structural unemployment by improving the match between skills and job requirements.

7.4 Policy mix and efficiency

• In the short run, demand‑side policies (fiscal/monetary) shift AD; supply‑side policies shift LRAS.
• Efficiency: policies that move the economy toward the LRAS without creating large inflationary gaps are considered more efficient.
• Equity considerations – redistribution of income through progressive taxation and welfare transfers.

8. International economics (Syllabus 6.1 – 6.5)

8.1 Balance of payments (BoP)

• Current account – trade in goods and services, net income, net transfers.
• Capital account – capital transfers (rare in Cambridge exams).
• Financial account – net acquisition of foreign assets (direct investment, portfolio investment, other investment).
• BoP identity: Current account + Capital account + Financial account = 0 (ignoring statistical discrepancy).

8.2 Exchange‑rate regimes

• Floating (flexible) rate – determined by market forces of supply and demand for the currency.
• Fixed (pegged) rate – central bank intervenes to keep the exchange rate at a predetermined level.
• Intermediate regimes – crawling peg, managed float, currency board.
• Exchange‑rate movements affect net exports: a depreciation makes exports cheaper and imports more expensive, shifting AD rightward.

8.3 Interaction with AD/AS

• Improved terms of trade (e.g., a depreciation) shift AD to the right via higher (X‑M).
• Supply‑side reforms that raise productivity shift LRAS rightward, increasing potential output without causing inflation.

9. Summary of key points (AO1)

• APC = \(C/Y_{d}\) – average share of disposable income spent on consumption.
• MPC = \(\Delta C/\Delta Y_{d}\) – extra consumption from an additional unit of disposable income.
• APC falls as income rises; MPC is relatively stable and determines the fiscal multiplier \(\displaystyle \frac{1}{1-\text{MPC}}\).
• Closed‑economy circular flow: Y = C + S. Open‑economy adds government and foreign sector: S + T + M = I + G + X.
• AD = \(C + I + G + (X-M)\); SRAS is upward‑sloping, LRAS is vertical at potential output.
• Growth = sustained rise in real GDP; sources are factor increase, productivity, and human‑capital improvement.
• Unemployment types and the natural rate; cyclical unemployment is addressed by demand‑side policy.
• Fiscal policy works through the multiplier; monetary policy works via interest rates and the money supply; supply‑side policy shifts LRAS.
• Balance of payments records all economic transactions; exchange‑rate regime influences net exports and thus AD.
• Policy effectiveness depends on the size of MPC/MPS, the position of the economy relative to LRAS, and the time‑lag of implementation.