Consumption

This section explains Consumption (C) covering, An Introduction to Consumption (C), Disposable Income and Its Influence on Consumer Spending, An Understanding of the Relationship Between Savings and Consumption, The Relationship Between Savings and Consumption, Other Influences on Consumer Spending, Consumer Confidence and Wealth Effects.

Introduction to Consumption (C)

Consumption (C) is one of the key components of aggregate demand (AD), representing the total spending by households on goods and services within the economy. It is typically the largest part of AD in most developed economies, including the UK. Understanding the factors that influence consumer spending is essential for analysing economic performance and formulating policy responses.

This guide explores the main factors that affect consumption, including disposable income, the relationship between savings and consumption, and other influences on consumer spending such as interest rates, consumer confidence, and wealth effects.

Disposable Income and Its Influence on Consumer Spending

What is Disposable Income?

Disposable income refers to the amount of money households have left after paying taxes and receiving any benefits. It is the income available to households for consumption or saving. Disposable income can be spent on various goods and services or saved for future use.

Influence on Consumer Spending:

The level of disposable income is one of the most significant factors influencing consumer spending. As disposable income increases, households generally have more money to spend on goods and services, leading to an increase in consumption. Conversely, if disposable income falls (for example, due to higher taxes or lower wages), consumption tends to decrease.

• Positive Relationship: There is typically a positive relationship between disposable income and consumption. When people have more disposable income, they are more likely to increase their spending. This effect is particularly pronounced for lower-income households, as they tend to consume a higher proportion of any additional income.
• Income Elasticity of Consumption: The degree to which consumption changes in response to changes in income is called the income elasticity of consumption. For lower-income households, the elasticity tends to be higher, meaning they are more likely to spend any additional income they receive.

An Understanding of the Relationship Between Savings and Consumption

The Saving Ratio:

The saving ratio refers to the proportion of disposable income that is saved rather than spent. A higher saving ratio means that households are saving a larger proportion of their income, whereas a lower saving ratio indicates that households are spending a larger proportion of their income.

The Relationship Between Savings and Consumption:

• Inverse Relationship: There is often an inverse relationship between savings and consumption. When households choose to save more, they reduce their consumption in the short term, and vice versa. For instance, during times of economic uncertainty, people may prefer to save rather than spend, which leads to lower consumption and can have a negative effect on overall economic demand.
• Marginal Propensity to Consume (MPC): The MPC refers to the proportion of an increase in disposable income that is spent on consumption rather than saved. A higher MPC means that households are more likely to spend additional income rather than save it. Typically, the MPC is higher for lower-income households, as they are more likely to spend their income on immediate needs.
• The Life-Cycle Hypothesis: This theory suggests that individuals plan their consumption and savings behaviour over their lifetime, aiming to maintain a stable standard of living. People may save more during their working years to fund consumption during retirement, which means there could be less consumption during working years but higher consumption in retirement.
• The Permanent Income Hypothesis: Proposed by Milton Friedman, this theory argues that people base their consumption decisions on their long-term or permanent income, rather than temporary fluctuations in income. For example, a temporary tax cut may not lead to a significant increase in consumption if individuals perceive it as temporary and save the extra income instead.

Other Influences on Consumer Spending

Several other factors influence consumer spending, in addition to disposable income and savings behaviour. These include:

Interest Rates

Interest rates have a significant impact on consumption. When interest rates are low, borrowing becomes cheaper, and saving becomes less attractive. This can encourage consumers to borrow more and spend more, particularly on big-ticket items such as houses and cars.

• Lower Interest Rates: When interest rates are reduced, it is generally cheaper for households to finance purchases on credit (e.g., mortgages, car loans, and credit cards), leading to higher consumption. Additionally, lower interest rates can also make saving less rewarding, further encouraging spending.
• Higher Interest Rates: Conversely, when interest rates rise, the cost of borrowing increases, which can reduce consumption. Consumers may cut back on spending as borrowing becomes more expensive, and saving becomes more attractive due to higher returns on savings accounts or other interest-bearing assets.

Consumer Confidence

Consumer confidence refers to how optimistic or pessimistic consumers are about their future economic prospects. If consumers feel confident about the economy, their income, and their future job security, they are more likely to increase spending. On the other hand, if they are uncertain or pessimistic, they may reduce their spending and increase their savings as a precaution.

• High Consumer Confidence: When consumers are confident, they are more likely to increase their consumption, even if their current income does not rise significantly. This is often the case in periods of economic growth or when employment is high, and people feel secure in their financial situation.
• Low Consumer Confidence: In times of economic uncertainty, such as during a recession, consumers may reduce their spending, choosing to save more in case of future economic difficulties. This reduction in consumer spending can have a significant impact on aggregate demand and can contribute to economic downturns.

Wealth Effects

The wealth effect describes the change in consumer spending that results from changes in the value of assets, such as property or stocks. When the value of these assets increases, consumers may feel wealthier and more willing to spend. Conversely, when asset values fall, people may feel poorer and reduce their spending.

• Increase in Wealth: If house prices or stock market values rise, consumers may feel wealthier and increase their consumption. This is especially true if individuals view their homes or investments as part of their long-term wealth. The increase in wealth can lead to higher spending on non-essential goods and services.
• Decrease in Wealth: If the value of assets falls (e.g., a housing market crash or a downturn in the stock market), consumers may feel less wealthy and reduce their spending, especially on luxury items or big-ticket purchases. This reduction in consumer spending can slow economic growth, particularly if the wealth effect is significant.

Summary of Key Points

• Disposable Income is the most significant factor influencing consumption, as higher disposable income typically leads to increased spending.
• The relationship between savings and consumption is generally inverse: when households save more, consumption tends to decrease, and vice versa.
• Interest Rates: Low interest rates generally encourage borrowing and spending, while high interest rates encourage saving and reduce consumption.
• Consumer Confidence plays a crucial role in determining whether households are likely to increase or decrease their spending. Higher confidence leads to higher consumption.
• Wealth Effects: Rising asset values can make consumers feel wealthier, leading to higher spending, whereas falling asset values can have the opposite effect.

By understanding these factors, you can better analyse the forces that drive consumption and, by extension, aggregate demand in the UK economy.