Consumption

What Determines the Level of Consumption?

Unsurprisingly the main factor is the level of disposable income. The more we have, the more we spend. So economic growth, leading to higher GDP and therefore household incomes is likely to result in higher consumption. Note that changes to income tax, national insurance or benefits will have an effect on consumption independently of changes to GDP, as they affect disposable income.

The way in which consumption changes with disposable income is called the consumption function. To understand the consumption function we need to look at the marginal propensity to consume (MPC) __and the __average propensity to consume (APC).

MPC = change in consumption ÷ change in disposable income

APC = total consumption ÷ total disposable income

Example

Disposable income rises from £100 millions to £120 millions per year. As a result consumer spending increases from £95 millions to £110 millions per year. What is the MPC?

MPC = change in consumption (15) ÷ change in disposable income (20)

MPC = 15/20 = 0.75

Using the above data, we can see that the APC changes as a result of the rise in disposable income:

From 95 ÷ 100 = 0.95

To 110 ÷ 120 = 0.92

The great English economist Keynes believed that the APC will decline as income rises, because households will be able to save a higher proportion of any increase in income the more income they have. This is reflected in the above example.

The evidence to support Keynes’s view is mixed. It certainly seems that higher income groups have a lower APC than those on lower incomes.

But for the economy as a whole, there is not much evidence to support this view. In the U.K for instance, real incomes have doubled over the last twenty years, but there is no sign of the APC falling. This may be because there are other factors apart from the level of disposable income that influence consumption. These include:

1. Consumer confidence – Households are generally more willing to spend, particularly on expensive consumer durables like cars financed by borrowing if they are optimistic about the future and their employment prospects. If a recession is expected they are likely to avoid taking on new borrowing and may save instead.
2. Inflation/deflation – If prices are rising and expected to continue to rise, households may bring forward some purchases, resulting in a short term boost to consumption. If prices are falling, the opposite applies, as people will postpone purchases in the hope of buying later at lower prices.
3. Interest rates – A rise in interest rates is likely to discourage consumption and encourage saving. It increases the opportunity cost of spending now, rather than waiting, as it involves the sacrifice of more interest that could have been earned. A fall in interest rates should have the opposite effect. But note that it is real rather than nominal interest rates that matter. If inflation is 10% and interest rates are 8%, the real rate of interest is actually negative (-2%), so consumer spending may still be strong, even though the nominal rate of interest is quite high. Note also that a fall in interest rates means mortgage holders have smaller monthly repayments, so may have more money available to spend. Changes in interest rates may also affect house prices and share prices and so have wealth effects (see below). Lower interest rates drive up house prices as mortgages are more affordable. Share prices may rise because savers may buy shares rather than keep savings in money balances earning low interest.
4. Wealth effects–This is the impact on consumer spending arising from changes in people’s wealth. __Wealth __means the money value of marketable assets that we own. For most people this is the value of their home, plus any savings they have, including pension ‘pots’ and shares. An increase in house prices or share prices increases household wealth and will encourage consumer spending, because households may not feel the need to save so much out of current income if their wealth is increasing.
5. The availability of credit – In recent years the de-regulation of banks has led to a big increase in the amount of household borrowing. This has enabled households to sustain high levels of spending even when incomes are not rising, or even falling. But it makes households vulnerable to a rise in interest rates.

Definitions

Consumption __comprises spending by households on both __consumer durables and consumer non-durables. The former include items such as furniture, electrical goods and household owned vehicles that will yield a use value over a significant period of time before being replaced. The latter refers to items that are quickly used up, such as groceries, entertainment and fast food. Like all types of spending, it is measured over a period of time.

Disposable income is gross income minus income tax and national insurance, plus state benefits.

For people on very low wages or who are not employed, disposable income may be higher than gross income, as they may depend to a large extent on benefits. Higher income groups will generally pay more tax than they receive in benefits, so disposable income is lower than gross income. Note that gross income includes all income, including interest, dividends and rent on property.

__Saving __is that part of disposable income that is not spent. It might be saved as cash in the bank, or go into a pension plan or shares. It is distinct from __savings __which refers to the accumulated balance built up over time. If I save £100 a month for a year, my savings will have grown by £1200.