29 Consumption and saving

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Key points:

Consumption can be divided into spending on durable and non-durable goods

The consumption function shows the relationship between consumption and its determinants, main being income

Consumption is affected by changes in interest rates, consumer confidence, wealth, the availability of credit, inflation and the composition of households

Defining consumption and saving:

Consumption is spending on consumer goods and services over a period of time

Examples are spending on chocolate, mobile phones or cars.

Consumption can be broken down Ito many different categories. A way of classifying consumption is to distinguish between spending on good and spending on services. Another way is to distinguish between spending on durable goods and spending on non-durable goods.

Durable goods are goods which continue to provide service over a period of time E.g. A car should last at least 6 years.

Non-durable goods are goods and services used up immediately or over a short period of time E.g. Ice cream or soap

Saving is what is not spent out of income. E.g. if a worker takes home £1000 at the end of the month but only spends £900, then £100 is saved

Saving may take the form of increasing the stock of cash or an increase of money in the bank or. it may take form of stocks or shares

Income in this case is disposable income, income including state benefits (like child benefits) after income tax and NI contributions are deducted

Consumption and income:

There are many factors which determine household consumption. The relationship between consumption and these factors are the consumption function. The most important determinant of the consumption function is disposable income.

Assuming a household has an income of £1000 per month. The next year, the salary increases, causing income to rise to £1200 per month. Economic theory would predict the consumption of that household will rise.

The amount it would rise can be measured by the marginal propensity to consume (MPC), the proportion of a change in income spent

MPC= Change in consumption/ Change in income

For the economy as a whole the marginal propensity to consume is most likely to be positive, greater than zero, but less than 1

Any rise in income would lead to a rise in consumption but saving too

For individuals, the marginal propensity to consume can be more Thant 1 if money was borrowed to fin cane spending higher than income

The average propensity to consume (APC), measure the average amount spent on consumption out of total income

APC = Consumption/ income

In a rich industrialised economy, the APC is likely to be less than 1 as consumers will also save part of their earning.

The Keynesian theory of consumption assumes income is the most important determinant of consumption. Keynesians suggested as income rose, households would prefer to save more so the average propensity to consume would fall. Also the higher income households would save a larger proportion of their income than poorer households. Redistributing income from high income earners to those on low incomes would therefore increase total consumption in the economy

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Other determinants of consumption:

There is a number of other determinants of consumption other than disposable income

Interest rates:

Households rarely finance expenditure on non-durables like food or entertainment by borrowing money

BUT much money used to buy durables like cars, furniture comes from credit finance

An increase in interest rates, increases the monthly repayments on these goods, it means the price of the goods have increased. Households react to this by reducing demand for durables and cutting consumption

Many households have also borrowed to buy their housed. Increased interest rates ;had to increased mortgage repayments. Again, it directly links to cut spending on other items and perhaps to discourage households from borrowing more money to finance purchases of durables

A rise in interest rates reduces the value of stocks on stock market and therefore recedes the value of household wealth which leads to a fall in consumption

Consumer confidence:

Purchases of consumer durables and non-essential items are affected by consumer confidence.

If consumers expect their situation to be the same or better in the future, they tend to maintain or increase spending. If they expect it to get worse, they are likely to hold back on purchases of non-essential items.

Consumer confidence deteriorates during a recession. Some workers worry they will lose their kens, others worry their pay will fall as they will work less overtime and bonuses will be cut. Consumers also worry banks will refuse to lend them money so they don't apply

In a boom, consumer confidence increases, boosting spending

Wealth effects:

The wealth of a household is made of 2 parts

Physical wealth is made up of items like houses, cars and furniture

Monetary wealth is made of items like cash, money in the bank, stocks and shares

If household wealth increases, consumption increases = known as the wealth effect

There are 2 important ways household wealth can change in a short time period:

A change in prices of houses. If the real prices of houses increases considerably, households feel able to increase spending. They do it mainly by borrowing more money secured against the value of their house

A change in value of stocks and shares. Households react to an increase in the real value of a households portfolio of securities by selling part of the portfolio and spending the proceeds. The value of stocks and shares is determined by many factors. One is the interest rate. If interest rates fall, the value of stocks rise SO consumption should be stimulated through the wealth effect by a fall in interest rate

The availability of credit:

Interest rate determines the price of credit

BUT the price of credit is not the only determinant of how much households borrow

Govt. in the past have often imposed restrictions on the availability of credit. E.g. they imposed Max repayment periods and min deposits

Before deregulation of the mortgage market, building societies rationed mortgages. They often operated queuing systems and imposed restrictive limits on sims that can be borrowed. When the restrictions were abolished, households increased their level of debt and spend the proceeds.

Making credit more widely available will increase consumption

Inflation:

Inflation has 2 effects on consumption

1) if households expect prices to be higher in the future, they will be tempted to bring forward their purchases SO expectations of inflation increase consumption and reduce saving

BUT it can be outweighed by the effect of inflation on wealth

2) rising inflation tends to erode the real value of money wealth, households react by attempting to reset the real value of their wealth by saving which reduces consumption

The consumption of households:

Young and old people tent to spend a higher proportion of their income than those in middle age.

Young people tend to spend all their income and more into debt to finance the setting up of their homes and bringing up children

In middle age, the cost of homemaking decline as a proportion of income

With more income available, households often choose to build up their stock of savings in prep for retirement

When retired, they will run down their stock of savings to supplement their pensions SO if there us a change in age composition of households in the economy there could also be a change in consumption and savings. The more young and old the households, the greater the level of consumption

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The determinants of saving:

Factors which affect consumption also by definition affect saving

The savings function therefore links income, wealth, inflation, interest rates, expectations and the age profile with the level of saving

BUT, because the typical average propensity to save (APS= Saving/income) is 0.05-0.2 in Western European countries, income is far less important in determining saving than it is in determining consumption

Factors other than income are therefore relatively ore important

Tha marginal propensity to save (MPS= change in savings/ change in income) is equally unstable

Confusion can arise between saving and savings. Saving is a flow concept which takes place over a period of time, saving is added to a stock of savings fixed at a point in time. A households stock of savings is the accumulation of past savings

Key terms:

Consumption- total expenditure by households on goods and services over a period of time

Durable goods- goods consumed over a long period of time

Non-durable goods- goods consumed almost immediately

Saving- the proportion of households disposable income not spent over a period of time

Disposable income- household income over a period of time including state benefits

Consumption function- the relationship between the consumption of households and its determinants

Marginal propensity to consume (MPC)- the proportion of a change in income which is spent. Calculated by change in consumption/ change in income

Average propensity to consume (APC)- the proportion of total income spend. Calculated by consumption/income

Wealth effect- the change in consumption following a change in wealth

Savings function- the relationship between savings of a household and its determinants

Average propensity to save (APS)- the proportion of a total income which is saved. Calculated by savings/ income

Marginal propensity to save (MPS)- the the proportion off a change in income which is spent. Calculated by change in savings/ change in income