Consumption

The Primary Influence: Disposable Income

Consumption is spending by households on goods and services. It is the largest component of aggregate demand in most economies.

Disposable Income: Income available for spending after direct taxes, such as income tax, and after adding government transfer payments, such as benefits.

The level of consumption is primarily determined by the level of disposable income. This is because households can only spend what they have available to them.

A rise in disposable income leads to a rise in consumption, and vice versa.

The Savings Relationship

Disposable income is split between consumption and savings - households can choose how to allocate their disposable income between these two uses.

The marginal propensity to consume (MPC) is the proportion of an increase in disposable income that is spent on consumption.

The marginal propensity to save (MPS) is the proportion of an increase in disposable income that is saved.

The MPC and MPS are related - a rise in the MPC means a fall in the MPS, and vice versa.

For example, if a household receives an extra £100 of disposable income and spends £80 of it, the MPC is 0.8.

Other Key Influences on Consumption

Interest Rates

A rise in interest rates increases the cost of borrowing and reduces the incentive to borrow. It also increases the reward for saving. Both effects reduce consumption.

A fall in interest rates reduces the cost of borrowing and increases the incentive to borrow. It also reduces the reward for saving. Both effects increase consumption.

Consumer Confidence

Consumer confidence is a measure of how optimistic households are about their future income and the state of the economy.

A rise in consumer confidence encourages households to spend more and borrow more, increasing consumption. A fall in consumer confidence encourages households to save more and borrow less, reducing consumption.

Wealth Effects

A rise in the value of household wealth, such as house prices or stock market investments, encourages households to spend more, increasing consumption. A fall in the value of household wealth encourages households to spend less, reducing consumption.

Distribution of Income

A more equal distribution of income encourages consumption, because lower-income households have a higher marginal propensity to consume than higher-income households. A more unequal distribution of income reduces consumption, because higher-income households have a lower marginal propensity to consume.