Theme 2 – Aggregate Demand - Consumption AD Component: Consumption The most important factor that determines consumption is disposable income - how much is left over of earnings after taxes have been paid). Unemployment is therefore a hugely impactful factor, when it comes to C and AD. Also you could consider discretionary income, which is disposable income (after taxes paid) but also with the additional subtraction of bills that the consumer is compelled to pay (rent, utilities etc.) Factors impacting consumption 1. Wealth effects: An increase in an individual’s wealth will cause consumption to increase i.e. increase in house prices or share prices. It is a psychological phenomenon that causes people to spend more as the value of their assets rises. The premise is that when consumers' homes or investment portfolios increase in value, they feel more financially secure, so they increase their spending. When house prices increase in value homeowners feel wealthier and they can spend more due to improved consumer confidence e.g. if they are in trouble they can sell their house. Equity extraction/release schemes may also mean they withdraw cash from their house and repay back the money through higher monthly mortgage repayments. However first time buyers who are not homeowners consumption may fall as they look to save more to provide a deposit. Closely linked to this is the ability to release equity and re-mortgage property. This allows the home owner to turn their equity into cash, particularly prominent if house prices increase. Large house prices increases were a principle driver of economic growth and consumption during the 1990s-2000s, through both the Wealth Effect and equity release schemes. 2. Cuts in income tax will increase disposable income – disposable income is the number one consideration when considering consumption. Income tax may mean that the tax free allowance (amount you can earn without paying income tax) is increased, or it could mean a reduction in the level of income tax paid when you do go past the tax free allowance threshold. 3. Increased availability of credit will increase consumption, in the form of credit cards, overdrafts, loans and mortgages. When a credit crunch occurs, banks do not feel confident enough to lend for fear that they will not receive their money back. This is an important point when considering the effectiveness of interest rates, because even if they are low and borrowing is more affordable, when a credit crunch occurs the banks are not willing to offer these low interest loans, overdrafts etc. In the long-term, credit can be damaging for consumption, as consumers find themselves having to pay back the money they owe and this can reduce future consumption. Aggregate demand fuelled by debt can be very damaging and have long-term implications. 4. Increase in population (including native births and immigration); this is simple in that the more consumers there are, the more consumption that will occur. A key argument in favour of immigration, is that it fuels aggregate demand through consumption and so eventually creates jobs. 5. Reduction in the rate of interest as saving is less attractive, it is cheaper to borrow (loans and credit cards) and mortgage repayments are reduced. However it will depend on the size of the interest rate cut. Mortgage repayments consist of the repayment off of the capital value of the loan (so actually paying off what is borrowed) and the interest rate on top of that. Changing the interest rate by even a Theme 2 – Aggregate Demand - Consumption quarter of a percent can have large impacts upon interest payments, as the interest is calculated based upon the outstanding capital owed – therefore (for example) 0.25% of £300,000 is still a significant sum. 6. Expectations and consumer confidence: when people are optimistic then consumption will increase; on the other hand if they are uncertain about their job security then consumption will fall. It is unlikely that consumers are going to make large purchases, if they have reason to believe that they could lose their job next week; instead they are going to save for a ‘rainy day’ to protect themselves against any future job loss and period of income reduction. Though it should be noted that when employees are made redundant, they are often paid redundancy payments to compensate the termination of their contract – this amount of money can counteract the lost income for a while, at least until a new job has been found. 7. Expectations of future prices, if individuals think prices will increase (inflation) they will bring forward their expenditure. However, if they think prices will fall (deflation) individuals will stall in spending – as they feel that if they wait a little longer, then the price of goods and services may fall further. This slows consumption within an economy and can be damaging. When considering inflation, the real wage needs to be taken into consideration – this is the increase in wages minus inflation – for example, if wages grow by 5%, but inflation is 6%, then actually the consumer has experienced 1% pay cut. When we consider wage growth with inflation, it is known as real and when we just consider wage growth on its own, it is known as nominal. In the previous example, the nominal wage growth is 5%. Marginal propensity to consume (MPC) Marginal Propensity to Consume measures how much, on average individuals spend of an extra unit of income e.g. how much they spend of an extra pound MPC = change in consumption Change in income When answering data response questions be prepared to relate MPC to the answer if this is appropriate – this can provide an excellent evaluation opportunity. If the MPC of a person is low (given as a decimal – how much of an extra pound do they spend), then their consumption will not increase as much when given additional income. Therefore giving additional income to consumers with a higher MPC, will have a more significant impact upon aggregate demand. In addition, the marginal propensity to import (MPM) is a further factor to consider – how much of additional income does a consumer spend on imports. When this figure is high (given as a decimal) then additional income will largely be spent on imports (which is a leakage) and so will not increase AD by as much. One way to solve this would be to introduce tariffs on exports, therefore diverting spending away from imports (reducing MPM) and towards domestic consumption (increasing C). NB: Consumption is the most important component of Aggregate Demand comprising approximately 65% of AD. This is a key evaluation tool. So see consumption as the most dominant category of AD.
