Consumption is spending by households on goods & services
In 2012 consumer spending in the UK was £927 billion out of a total GDP level of £1504 billion
Consumption is the biggest single component of aggregate demand, in 2012 it was 61% of GDP
Many factors affect the ability of people to spend and this has a large effect on the economic cycle
Disposable income and spending – the propensity to spend
John Maynard Keynes was undoubtedly one of the major figures in the history of economics developed a theory of consumption that depended mainly on disposable income. Disposable income is income after direct taxes and welfare benefits.
The Propensity to Consume
What matters is the rate at which consumers increase their spending as income rises. This is called the marginal propensity to consume. Say that someone receives extra pay of £2000 in a year and they spend £1500, thus the marginal propensity to consume is £1500 / £2000 = 0.75. The remainder is saved so the marginal propensity to save is 0.25.
A simple rule to remember is that the marginal propensity to consumer added to the marginal propensity to save must always equal 1.
Generally, people on lower incomes tend to have a higher propensity to spend. This matters when the government announces changes in taxation and the level of welfare benefits. A fall in the marginal propensity to spend will cause a lower level of consumption for a given level of income.
Some Factors that Determine Consumer Spending
Many factors have an influence on the total level of consumer spending in an economy.
- Real incomes – if people’s money wages rise faster than prices, then real incomes will increase and this leads to a higher level of real purchasing power
- Direct and indirect taxation – if there is a cut in direct taxation then, other factors remaining the same, consumers will experience an increase in their disposable income and spending power. In contrast, a hike in indirect taxes such as import duties or VAT will cause prices to rise and real incomes to decline.
- Interest Rates – lower interest rates cuts the cost of paying the debt on a mortgage and increases the effective disposable income of homeowners. In recent years many central banks around the world have made deep cut in interest rates in a bid to stimulate consumer demand. Official interest rates in the UK have been at 0.5% since March 2009.
- Household Wealth – for example a sustained fall in house prices might cause a decline in personal wealth and spending as homeowners have less housing equity available to borrow. This is sometimes referred to as the negative wealth effect. Housing equity is the difference between the market value of property and the outstanding mortgage loan.
- Consumer Confidence – for example, fears of rising unemployment and expectations of higher taxes will hit consumer sentiment and spending. If you don’t have enough confidence, you are unlikely to go ahead with major purchases such as a new car or kitchen.
- The Supply of Credit: One of the features of the credit crunch has been a slump in the flow of credit available for many households and businesses – banks have become less willing to lend and if they do, the rate of interest on the loan has increased. The supply of mortgage finance has dried up and would-be homebuyers now need to find a bigger deposit before getting a home loan.
- The Distribution of Income: Lower income families tend to have a higher propensity to consume than better-off households (who tend to have a higher savings ratio). Thus a redistribution of income towards poorer families may have the effect of boosting total consumer demand.
- Demographics: The size and growth rate of a country’s population and the age structure has a direct effect on total consumer spending. Some countries have a strongly positive natural rate of population growth perhaps aided by net migration of labour. An expanding population will add to demand for many different goods and services including housing, health care and education.
Consumer confidence is measured using surveys that ask people about their own financial situation and expectations for themselves and the economy. When consumer confidence is low people save more because of fears about job security and future income.
The Wealth Effect
- Wealth represents the value of a stock of assets
- For most people the majority of their wealth is held in property, shares in quoted companies on the stock market, savings in banks, building societies and money building up in occupational pension schemes
- Many economists think that there is a positive relationship between wealth and spending although the size of the effect is open to question.
- For millions of people, assets in the form of savings and occupational pension schemes are important. So the real value of their savings and the income that flows from deposit accounts from interest payments will have a direct effect on their spending power.
- In recent years the average rate of interest on UK savings deposits have less than the rate of inflation – causing a cut in the real purchasing power of savers
Most of us at some time in our lives need to borrow money to finance spending. The credit market for individuals is complex. Broadly speaking we can distinguish between:
- Unsecured borrowing – that is a loan or an overdraft which is not tied to the value of another asset. Examples of this are student overdrafts, bank loans and money borrowed on store and credit cards
- Secured borrowing – is lending where the borrower must use another asset as collateral for the loan. The best example of this is a mortgage with a bank or building society. Home buyers are at risk if they fail to keep up with monthly mortgage repayments and ultimately, the lender may foreclose and seek repossession of the property.
One of the most important features of the British economy in recent years has been the high levels of borrowing. To use a technical term, what we have seen is a ‘leveraging up’ of the consumer sector – people seem to have been happy to increase the ratio of their debt to income with the result that the UK still has one of the highest debt-to-income ratios of any of the leading economies.
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