# 3. What determines the levels of household

```What determines the levels of household consumption and investment?
1. Factors influencing consumption

Expectations: If a consumer thinks their income will rise in the near future they
will ____________________ consumption now. If they expect prices to rise they

Interest rates and availability of credit: If interest rates are reduced,
consumption will_____________ as the cost of borrowing is ________________.

Wealth: If consumers’ wealth increases, spending may be high even if income is
low. For example, if you were to receive property through the death of a relativeyour wealth has increased (but your income has not) and you may spend more as
a result of this wealth ‘feel-good’ factor.

Distribution of income: If income is redistributed and taken from high-income
groups and given to low income groups, consumption is likely to rise. This is
because the low-income groups tend to spend more out of each dollar. (see below)

Real disposable income: The true purchasing power of the money in your
pocket/wallet/bank after taxes. This is the single most important factor in
determining the level of household consumption.
The proportion of total income spent is known as the average propensity to consume
(apc).
APC = total consumption/total disposable income
Activity 1
Do the following calculations with apc, disposable income and consumption.
1. What is the apc of a person who spends \$350 out of a disposable income of \$500.
2. If a man has a disposable income of \$600 and an apc of 0.75, how much does he
spend?
3. If a woman who spends \$400 has an apc of 0.8, what is her disposable income?
Note, although the total amount spent usually rises as disposable income rises, the
proportion spent- the apc- usually falls. A poor family may have an apc of 1 or even
greater (how is this possible?______) because they will have to spend all their income
just to buy necessities. As the family becomes richer their apc may fall as they might
have to spend only 80% of their total income to buy the same (or a greater) quantity of
goods and services.
So as income rises people tend to spend a smaller proportion of their income. The
proportion of extra income spent is known as the marginal propensity to consume
(mpc).
mpc = change in consumption/change in disposable income
Activity 2
Do the following calculations with mpc
1. If a person’s income rises by \$400 and her spending rises by \$140, what is her
mpc?
2. If a man with an mpc of 0.5 experiences a rise in income of \$60 how much extra
will he spend?
3. If a woman has an mpc of 0.9 and her income rises by \$700 how much will her
spending increase by?
Activity 3
Disposable income \$
100
200
300
400
500
600
Consumption \$
120
200
270
320
350
360
apc
mpc
Savings and income
Savings is the part of disposable income which people do not spend. It is calculated from
disposable income less consumption. As with consumption, the main influence on
savings is the level of income. As incomes rise you would expect the average household
to _____________ savings. The proportion of income that is saved is called the average
propensity to save (aps)
APS = total savings/total disposable income
APC + APS = ????
The marginal propensity to save is the change in saving resulting from a change in
income.
mps = change in saving/change in disposable income
MPC+MPS = 1
Activity 4
Do the following calculations on saving.
1. A woman saves \$60 out of her income of \$200. What are her aps and apc?
2. A man’s income rises by \$80 and as a result his savings increase by \$20. What is
his mpc and mps?
3. If a woman has an mpc of 0.9 and her income rises by \$300 how much will her
savings increase by?
Activity 5
Disposable
income \$
100
200
300
400
500
600
700
800
Consumption
\$
100
190
270
340
400
450
490
520
saving
aps
apc
mps
mpc
2. Factors influencing the level of Investment Expenditure
The level of investment depends on:




availability of finance
interest rates
the expected rates of return from the investment- what you hope to get back in
EXPECTATIONS- what will demand be like in the future? Future prices?
Economic outlook?
Interest
Interest is the return on capital AND the cost of borrowing money. The interest paid
for borrowing money will depend on:



How long the loan is for- generally if you borrow for a longer time you are
charged more
Risk- the riskier the project the more the lender will usually charge
The size of the loan- smaller loans tend to attract higher rates on interest
Higher interest rates make the cost of borrowing more expensive for households and
firms, e.g. loans, credit cards, overdrafts, mortgages. They also make savings more
attractive.
Levels of interest rates and investment can be graphically represented on an investment
schedule like the one below.
Interest
rate (r)
%
With an increase in interest rates,
investment is likely to fall. This is
because it is more expensive to borrow
and there are now fewer projects, which
have a higher rate of return than the cost
of borrowing.
With a lower interest rate, more
projects become profitable (as
the cost of borrowing has fallen)
and investment increases.
Investment (I)
```