Consumption
Consumption is the largest single component of AD (60% of
it). According to Keynes the most important determinant of spending by
households is disposable income. Therefore as real incomes rise, households
will tend to spend more. Keynes also pointed out that they wouldn’t spend all
of it but would save some. Keynes defined the average propensity to consume
(the proportion of income that households devote to consumption) as the ratio
of consumption to income. And the marginal propensity to consume (the
proportion of additional income devoted to consumption) as the proportion of an
increase in disposable income that households would devote to income.
However income isn’t the only influence on consumption as it
may also depend on the wealth of a household. Income and wealth aren’t the
same; income accrues during a period as a reward for the supply of factor
services (labour). On the other hand, wealth represents the stock of
accumulated past savings. If households experience an increase in the value of
their asset holdings (wealth) then this may influence their spending decisions.
If parts of household spending are financed by borrowing then
the rate of interest is significant in influencing the total amount of
consumption spending. An increase in the rate of interest may deter consumption
and vice versa. At the same time it may encourage saving. The rate of interest may
also have an indirect effect on consumption through its effect on the value of
asset holdings (wealth). Households may adjust their consumption based on their
expectations about inflation.
Some of these determinants aren’t instantaneous and so there is a time lag for consumption to adjust.
The consumption function is the relationship between consumption and disposable income. Its positions depends on other factors that affect how much households spend on consumption. The graph above shows the relationship between consumption and real income ceteris paribus (other determinants such as wealth and interest rate remain constant). The Marginal Propensity to Consume (MPC) is the line, if MPC was 0.7 then for every additional £100 of income received by households, £70 would be spent on consumption and £30 would be saved.
A non price factor that will lead to increased consumption is a Feel Good Factor or Consumer Confidence. If consumers are confident about the future (they believe that their real incomes will remain constant or will increase or they will receive a wealth boost perhaps through inheritance or a form of lottery) then consumption will increase, the same applies if there is a Feel Good Factor affecting them.
Consumption is considered an autonomous component as even when income levels are zero people will still spend on necessities such as food and shelter. They would finance this through depleting their savings or by borrowing.
The Effect
of House Prices on AD
For existing house owners if the price of houses falls then
they will see a negative wealth effect and will reduce their spending.
Confidence in this group will be low, and vice versa.
For new first time buyers a fall in house prices will be
positive as they have to borrow less and will have more disposable income after
paying their mortgages. Therefore consumption will increase, and vice versa.
The overall effect on consumption and on AD will depend upon
the relative strength of these 2 groups (whichever is larger).
Page last updated on 20/10/13
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