A central argument we have made on this blog and in our book is that the distribution of income/wealth matters a great deal for thinking about the macro-economy. Convincing some of this fact is not easy — many continue to work within a modeling framework in which all distributional considerations are assumed away, the so-called “representative-agent” framework.
Perhaps the easiest way to see the importance of the income distribution is to examine how households respond to a windfall of cash or wealth (possibly due to an inheritance or being able to successfully build a side income). Do they spend the money, or do they save it? And does the spending response to a windfall of cash depend on the income of the household?
The answer is a resounding yes: low income households spend a much higher fraction of cash windfalls than high income households. In the parlance of economics, low income households have a much higher marginal propensity to consume, or MPC, than high income households.
This is one of the most well-established facts in empirical research in macroeconomics. Here is a summary:
- Low income households spend a much higher fraction of fiscal stimulus rebate checks. See the evidence here and here. For the 2001 stimulus checks, low income households spent 63% more of their rebate check than high income households.
- During the Great Recession, for the same decline in housing wealth, low income households cut back on spending much more. See here. The spending response of low income households is twice as large as that for rich households.
- During the housing boom from 2002 to 2006, we see the same result. For the same increase in home values, low income households very aggressively borrow and spend. In contrast, high income households are almost completely unresponsive.
- If a credit card company increases the limit on an individual’s credit card, individuals that are close to the limit spend a much larger fraction of the increased limit. See the evidence here. Individuals right up against the limit spend $0.45 for every $1 of increase in the limit, whereas individuals with plenty of room on their credit card spend only $0.07 for every $1. While this is not exactly a difference across income levels, credit card utilization rates are highly correlated with income so it applies pretty well.
The implications of the differences in spending propensities across the population are enormous, especially if we believe that inadequate demand explains economic weakness during severe recessions. For example, facilitating debt forgiveness or progressive fiscal stimulus rebates will likely boost spending during the most severe part of a recession.
But perhaps even more interesting are the implications for the secular stagnation hypothesis, which holds that we are in a long-run stagnating economy because of inadequate demand. Is it a coincidence that the secular stagnation hypothesis is being revived exactly when income inequality is accelerating? If a higher share of income goes to the wealthiest households who spend very little of it, then perhaps these two trends are closely related.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
