A2 Macro: Consumer Spending

Consumer (or household) spending on goods and services is driven by a number of factors, the relative importance of which will vary over the course of an economic cycle and from one cycle to another. The Keynesian theory describes a consumption function where household spending is directly linked to people’s disposable income

The standard Keynesian consumption function is written as follows:
C = a + c (Yd)

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

Autonomous spending (a) does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income.

The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. If for example your disposable income rises 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 of the increase in income, then the mpc would be 0.5.

Shifts in the Consumption Function

A change in any factor affecting consumption other than a change in income is said to 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 might boost consumption at each level of income and cause an upward shift in the consumption function. Lower interest rates act to lower the cost of servicing the debt on a mortgage and thereby increase the effective disposable income of homeowners. One of the features of the current recession has been the sharp reduction in ‘policy interest rates’ by central banks. Nominal interest rates in the UK have been cut to 0.5% and are likely to stay there for some time. But despite this consumption has remained weak – people have not responded to the cut in the cost of borrowing.

o A change in household wealth – for example a sustained fall in house prices might cause a decline in personal sector wealth and spending as homeowners have less housing equity available to borrow. This is sometimes referred to as the wealth effect.

o A change in consumer confidence – for example, fears of rising unemployment and expectations of higher taxes will hit consumer sentiment and spending

o A reduction in the supply of credit: One of the features of the credit crunch has been a large fall in the availability of credit for 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 home buyers now need to find a bigger deposit before getting a home loan. The loan to valuation ratios have fallen that has affected people’s ability to borrow to fund property purchases

Bank of England Target 2.0 from Timetric