Aggregate Demand AD = C + I + G + X – M

Consumption What determines the level of consumption, or whether consumption should rise or fall? In pairs, discuss the influence on the card you have been given. You will need to prepare a presentation to the rest of the class. You are looking at income, wealth, interest rates, consumer confidence

Main influences on consumption 1.Income – Disposable income (income after tax) is the main determinant of what a household spends. Includes private income but also state benefits – Total consumption expenditure in the economy will therefore be affected by what is happening to wages and income tax, but also by the number of people with a job – Some income is saved. The proportion of any increase in income which is spent is called the marginal propensity to consume (MPC) If I earn £1000 more this year after tax, how much of that do I spend? (the rest is saved) MPC = ΔC = Δ Consumption ΔYΔ Income – Consumers will mostly consider current income, but will also take into account expected future income

More consumption 2.Wealth – Wealth consists typically of financial assets (shares, bonds and savings) and housing – Most research shows that consumers will spend more as wealth increases An increase in wealth may be thought by consumers to mean higher income in the future Or it might be that asset prices are increasing for reasons which increase confidence, such as a strong economy – An increase in house prices may increase spending because of greater optimism about the future, but note that it also means it is more expensive for the next move or for first time buyers – The rise in consumption from increasing wealth is called the wealth effect 3.Interest rates – Higher interest rates generally mean lower consumer spending – The first reason is that borrowing costs rise, which will tend to depress spending on consumer durables such as cars – The second reason is that returns on savings are more attractive, which can mean an increase in the savings rate – Also, those with mortgages will face higher interest costs on existing debt, so have less money to spend after paying their monthly mortgage cost

Last consumption 4.Confidence/expectations – Very important influence on spending, but very difficult to assess accurately No precise correlation between spending and indicators of consumer confidence – Greater confidence and certainty in the future will be associated with higher spending. This has happened over the last 2-3 years as unemployment has fallen – If consumers become uncertain about the future, in particular about their future income, eg from risk of unemployment, they will spend less 5.Other point. Credit – The availability of credit can affect consumption. This is the case now, with banks less willing to lend. Also, house buyers now need to pay a larger deposit, which means increased saving

MPC and APC Consumption depends on a range of factors, as discussed, but particularly on income. C = a + bY (where Y is income) As Keynes (Cambridge economist and founder of modern macroeconomics) remarked, “men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in their income” How much of a household’s income is spent is called the average propensity to consume APC = The marginal propensity to consume measures the proportion of an increase in income that is spent MPC = The blue line represents consumption if all income is spent The red line is actual consumption, showing that with no income, households still spend some money, drawing down on saving or borrowing The slope of the red line is the marginal propensity to consume, g/h, or b which shows as income increases, so does consumption, but not by as much Consumption Income Change in consumption Change in income =

Example Income (Y)Consumption (C)Saving (S) What is the MPC? What is the APC at an income of 200? What about at an income of 300? All else equal (ceteris paribus), as income increases both consumption and saving increase The higher the income, the lower the APC (those on higher incomes can afford to save The MPC may also fall as incomes rise A note on saving and savings Saving is what is not spent out of income Savings represents accumulated saving (like wealth), so each year increases by the amount of saving