consumer spending

7/31/2019 Consumer Spending

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Definition of 'Consumer Spending'The amount of money spent by households in an economy. The spendingincludes durables, such as washing machines, and nondurables, such as food. Itis also known as consumption, and is measured monthly. John Maynard Keynesconsidered consumer spending to be the most important determinant of short-

term demand in an economy.

Investopedia explains 'Consumer Spending'Often these monthly numbers are compared to the previous month or the same

month of the previous year. When the government wants to stimulate the

economy it will attempt to increase consumer spending. This can be done by tax

cuts or even through giving out a lump sum or money. The increased income is

expected to cause individuals to buy more, which means companies will

experience higher revenues and can potentially hire more workers.

Read more:http://www.investopedia.com/terms/c/consumer-

spending.asp#ixzz1vaaONKtD

A 2 M a c r o e c o n o m i c s / I n t e r n a t i o n a l E c o n o m y

Consumer Spending & SavingThe basic determinants of consumer spending and saving were covered as part ofthe AS course. In this section we delve deeper into the determinants of

consumption exploring in particular the Keynesian approach and alternativetheories of consumption and saving.

The consumption functionThe consumption function is simply a theoretical relationship between incomeand consumer expenditure. The Keynesian theory describes a consumptionfunction where household spending is directly linked to peoples disposableincome. A simplified consumption function diagram is shown below.
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The standard Keynesian consumption function is written as follows:C = a + c (Yd) - where

C is total consumer spending a is autonomous spending And c (Yd) is the propensity to spend out of disposable income

Autonomous spending (a) is consumption which does not depend on the level ofincome. For example people can fund some of their spending by using theirsavings or by borrowing money from banks and other lenders. A change inautonomous spending would in fact cause a shift in the consumption functionleading to a change in consumer demand at all levels of income.

The key to understanding how a rise in disposable income affects householdspending is to understand the concept of the marginal propensity to consume(mpc). The marginal propensity to consume is the change in consumer spendingarising from a change in disposable income. If for example your disposable incomerises by 5,000 and you choose to spend 3000 of this on extra goods and services,then the mpc is 3000/50000 or 0.66. If you chose instead to spend only 2500 ofthe increase in income, then the mpc would be 0.5.


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The gradient of the consumption function shown in the previous diagram isdetermined by the value for marginal propensity to consume. A change in thempc (shown in the next diagram) would cause a pivotal change in the consumptionfunction. For example, a decision to save less of any increase in income wouldlead to a rise in the mpc and a steeper consumption curve.

The consumption function - a simple numerical example

Disposable Income (Yd) Consumption (C) Average Propensity toConsume = C/Yd

Marginal Propensity toConsume = change in Cfrom a 1 change in Yd

10000 8500 0.85

20000 16000 0.80 0.75

30000 23600 0.79 0.76

40000 29450 0.74 0.59

50000 33200 0.66 0.38

In our example above, as disposable income rises in blocks of 10,000, so doestotal consumption. But the rate at which consumer spending is increasing isdeclining. The marginal propensity to consume is falling and this brings down theaverage propensity to consume.The Keynesian theory did actually argue that themarginal propensity to consume would fall as income increases, but the evidencefor the UK over many years disputes this.

The Savings FunctionWe assume that any disposable income that is not spent is saved, so we candeduce from our numerical example above, that because the marginal propensityto consume is falling, then the marginal propensity to save must be rising as is

the average propensity to save (otherwise known as the household savings ratio).This is shown in the table below which is drawn from the data on consumption andincome used in the first table.

The Savings Function - a simple numerical example

Disposable Income (Yd)

Saving

(= Yd C)

Average Propensity toSave = S/Yd

Marginal Propensity toSave = change in S from

a 1 change in Yd

10000 1500 0.15

20000 4000 0.20 0.25

30000 6400 0.21 0.2440000 10550 0.26 0.41

50000 16800 0.33 0.62


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The savings ratio is quite volatile but what have been the main trends since 1990?

Looking at the data for the household savings ratio we find that it has been quitevolatile over the last fifteen years ranging from over 13% of disposable income in1992 to just 3% of disposable income in 2004. It is noticeable that in recent years,households have chosen to save a lower percentage of their after-tax income thanin previous periods. Much of this has been the result of the boom in consumerborrowing, including a huge level ofmortgage equity withdrawal from thehousing market.

By the summer of 2005 it was clear that the borrowing boom was coming to an endin part the result of a sharp slowdown in the rate of growth of house prices. In the

last couple of years there has been a steady rise in the savings ratio with its valueheading up towards 6%. This has coincided with a period of weaker consumerdemand for goods and services. People have obviously decided to save a littlemore in order to repay some debt and generally improve their household finances.Perhaps they fear rising unemployment and the risks of defaulting on their loans?


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Unemployment and interest rates both influence savings decisions

In the chart above we track the household savings ratio, the base rate of interestset by the Bank of England and the seasonally adjusted rate of unemployment asmeasured by the claimant count. The general trend is that the savings ratio hasdeclined over the last decade or more, a time when both unemployment andinterest rates have also fallen. If people have reasonable expectations of jobsecurity and if the rate of return on their savings is lower than in the past, hereare two reasons to save less and borrow more.

Notice in the next chart how the incredibly strong demand for consumer borrowinghas tailed off in the last two years. The annual growth in demand for consumer

credit exceeded 10% from 1994 through to the middle of 2005. The growth ratehas since dipped sharply lower; perhaps our love affair with the plastic card (40years old in 2006) is coming to an end? In contrast, the rate of increase inborrowing secured on the value of property has remained very strong. Borrowingmoney represents dis-saving because it allows someone to spend in excess of theircurrent income.

The issue ofconsumer debtis a long-standing one. It certainly raises risks for the
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UK economy in the years ahead because the accumulation of debt creates the costof servicing this debt, thousand of people have problems in simply paying theinterest on their loans and the number ofpersonal insolvenciesin the UK hasreached a record high.

The last ten years has seen a credit boom in the UK now coming to an end?
http://news.bbc.co.uk/1/hi/business/4976180.stmhttp://news.bbc.co.uk/1/hi/business/4976180.stmhttp://news.bbc.co.uk/1/hi/business/4976180.stmhttp://news.bbc.co.uk/1/hi/business/4976180.stm


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Personal insolvencies are now at a record high too much borrowing? Or is it nowtoo easy to declare oneself bankrupt and avoid repaying existing debts?
http://business.guardian.co.uk/Money/creditanddebt/story/0,,1837871,00.htmlhttp://business.guardian.co.uk/Money/creditanddebt/story/0,,1837871,00.htmlhttp://business.guardian.co.uk/Money/creditanddebt/story/0,,1837871,00.html


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There is a strong relationship between peoples disposable income and their

spending

Shifts in the Consumption Function


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A change in any factor affecting consumption other than a change in income is saidto lead to a shift in the consumption function. These factors include the following:

o A change in interest rates for example a cut in interest rates will boostconsumption at each level of income and cause an upward shift in theconsumption function. Lower interest rates act to lower the cost of

servicing the debt on a mortgage and thereby increase the effectivedisposable income of homeowners. In contrast a period of higher interestrates is designed to curb consumer spending.

o A change in household wealth for example a rise in house prices or inshare prices encourages higher levels of borrowing and an upwardmovement in the consumption curve

o A change in consumer confidence for example, expectations of risingunemployment and worsening expectations of changes in income might leadto a reduction in confidence and a fall in spending at each level of income.Conversely an improvement in consumer expectations about the health ofthe economy will increase confidence and planned spending

Consumer spending in Britain has grown consistently strongly in recent yearsalthough during 2005 there was a clear slowdown from the fast rates of growthseen particularly in 1999 and 2000. It is also interesting to note that householdconsumption has been growing more quickly than real national income implyingthat consumption as a share of GDP has also been rising. The evidence for this is


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shown in the next table.

Consumption RealDisposable

Income

Real GDP AveragePropensity to

Consume

Consumption / GDP

billion at constant 2002 prices =C/Yd Ratio of consumption to real GDP

1997 558.1 625.2 936.7 0.89 0.60

2005 731.1 768.6 1167.8 0.95 0.63

Source: ONS, Blue Book

We now turn to some non-Keynesian theories of what determines consumerspending.

Alternative theories of consumption

The lifecycle modelThe life-cycle model of consumption was developed by Franco Modigliani whoargued that households form a view about their likely or expected income over alarge slice of their life-cycle, and then base their spending decisions around this.This helps to explain why people in reasonably well paid jobs in their early


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twenties are prepared to borrow heavily to finance current consumption (a newcar, furnishings for a property) because they expect to be able to repay loans astheir disposable income increases. Similarly people reaching middle age frequentlytend to become net savers because they are anticipating saving for theirretirement. One of the results of the life-cycle model is that changes in the age

structure of the population can have sizeable effects on total consumer spendingin the economy.

The permanent income modelThis model of consumption is associated with the US economist Milton Friedmanand it is, in many ways, a development of the life-cycle mode. Friedman believedthat people base their spending decisions on expectations of permanent income.Permanent income might be described as the average income that people can earnover their lifetime. A distinction is made between transitory income (e.g. awindfall gain in income which has not been earned) and permanent income.Friedman believed that changes in transitory income would not fundamentallyaffect spending and saving decisions. But that shifts in permanent income wouldbe important in shaping our spending levels.

For example, a rise in household wealth increases the ability of people to spendperhaps through borrowing secured on the value of a property. Lower interestrates tend to increase both share and house prices adding to household wealth.That said lower interest rates also cut the income flowing to people with netsavings.

According to the permanent income model, only changes in permanent income

have any long term effect on consumption. But transitory changes in spendingpower can lead to a more volatile pattern for the propensity to consume.

Key Points

Keynesian theories of consumption focus on current disposable income asthe main determinant of household spending

Other theories argue that expectations of income and wealth in the futurealso affect peoples spending decisions

Borrowing allows people to spend more than their current income.Borrowing is dis-saving

The consumer borrowing boom has lasted more than a decade Household debt is now at a record high although interest rates remain low

by historical standards Rising house prices have boosted personal wealth and consumer confidence Personal insolvencies are rising, debt is likely to be a major constraint on

consumer demand for goods and services in the years ahead


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consumer spending

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