Chapter 4
The Consumption Function
Principal Determinants of
Consumption (Slide 1)
•
•
•
•
•
Recent average disposable income (DI)
Expected average DI
Changes in income tax rates
Cost and availability of credit
Demographic factors and age distribution
of consumers
Principal Determinants of
Consumption (Slide 2)
• Expected rate of return on assets: debt,
equity, and real estate
• Changes in spendable income not
included in DI caused by fluctuations in
asset prices
• Exogenous shifts in consumer attitudes
not related to any of the above variables
Recent Average Disposable
Income (DI)
• Income from All Sources
• Wages, Income from Capital, and Transfer
payments
• Income and social security taxes are
deducted, but not sales and excise taxes
• Some income is not included, primarily
from capital gains and home refinancing
Expected or Average DI
• Most people base their spending on average or expected
income, rather than the most recent paycheck. This is
usually known as the permanent income hypothesis.
• A few examples:
• You win the lottery, but you don’t spend all of it that
month.
• You become unemployed, but your consumption doesn’t
drop to zero.
• You save in anticipation of the children’s college
education, then dissave during the years they are
actually in college
Changes in Income Tax Rates
• This remains a politically charged issue, but
most economists agree that:
• A permanent change in tax rates has a larger
impact on consumption than a temporary
change.
• Consumers are likely to spend a larger
proportion of any tax cut if they are optimistic
about the future
• It is possible that while consumption rises
because of a tax cut, imports also rise, so the
net effect on real GDP is much smaller.
Demographic factors and age
distribution of consumers
• The Life Cycle Hypothesis states that
young people will dissave when they are
just starting their careers, will maximize
their saving rate shortly before retirement
age, and then dissave again during
retirement years.
• That implies that the general aging of the
population would reduce the personal
saving rate.
Cost and Availability of Credit
• A key determinant, especially with the
proliferation of credit cards, home equity
loans, and other sources of borrowing.
• Imposing actual credit controls has an
immediate and drastic impact on
consumer spending, but for that very
reason probably would not be utilized
again except in extreme circumstances.
Excessive Credit Sensitivity
• The PIH and LCH state that when income
declines, consumption does not decline as
much. Hence the personal saving rate would
decline in recessions
• However, we find empirically that the saving rate
rises during recessions.
• This is usually referred to as excessive credit
sensitivity. Even if consumers plan to spend
based on their permanent income, they may
have to cut back if borrowing sources are
diminished. This applies mainly to purchases of
durable goods.
Cost of Credit
• Five possible reasons why the personal saving
rate is positively correlated with interest rates.
• When interest rates rise, people save more now
so income and consumption can be higher later.
• Average monthly payment rises, reducing
demand.
• Stock market declines
• Housing prices rise less rapidly, so less home
equity financing and refinancing
• Yield spread narrows, so credit availability
diminishes.
Expected Real Rate of Interest
• Argument is complicated by fact that when
interest rates rise, it is usually because inflation
rises, so the expected real rate of interest may
not increase.
• Suppose interest rates went from 5% to 15% at
the same time that inflation went from 2% to
12% (as in the late 1970s). People would have
no additional incentive to save.
• As a result, this is the weakest empirical link
between interest rates and the saving rate.
Cost of Time Payments
• This applies mainly to purchases of motor
vehicles.
• Higher interest rates raise the monthly time
payment or lease payment substantially.
• “Zero interest rate” financing boosted motor
vehicle sales sharply even though the average
reduction in the monthly payment was only
about 2%, since low interest rates enabled
manufacturers and dealers to absorb some
losses on existing leases when consumers
bought new motor vehicles.
Changes in Stock Market
• Of course stock prices depend on many
factors other than interest rates, yet it is
true that lower interest rates will lead to
higher stock prices, ceteris paribus.
• Since a rising stock market boosts
consumption relative to disposable
income, there is a positive correlation
between the saving rate and interest rates
for this reason.
Impact on Housing Financing
• Housing prices show a strong negative
correlation with interest rates.
• As rates decline, housing prices rise faster, so
more homeowners can cash out some of this
increased equity.
• Lower interest rates also permit more people to
refinance, hence reducing their monthly
mortgage payment – which is not counted as
part of consumption – and increase purchases
of other goods and services.
Yield Spread
• The yield spread between long and short-term
interest rates is a major determinant of
consumer spending and total GDP.
• Usually, long-term rates are higher than shortterm rates. However, when the reverse is true –
known as an inverted yield curve – the U.S.
economy has always headed into a recession
the following year.
• When the yield spread becomes inverted, banks
will reduce the amount of loans made to
consumers, hence diminishing purchases.
Expected rate of return on assets:
debt, equity, and real estate
• If consumers expect the rate of return on
assets to rise, they will generally spend a
higher proportion of their income. That is
particularly true for housing, where rising
prices cause many people to “cash out”
some of their increased equity.
• A rising stock market generally leads to an
increase in the ratio of consumption to
disposable income
Changes in spendable income caused by
fluctuations in asset prices not included in DI
• This has become an increasingly important
factor in recent years. Capital gains are not
included in disposable income even if they are
realized. Thus during a rising stock market, part
of the reported decline in the personal saving
rate could be due to an increase in realized
capital gains.
• Also, many people cash out some of their
increased equity when housing prices rise.
• When interest rates decline, homeowners may
refinance, hence boosting the amount of income
they have to spend on other items.
Exogenous shifts in consumer attitudes not
related to any of the above variables
• Consumers will spend a higher proportion
of their income if they are optimistic about
the future, and spend less if they are
pessimistic. Virtually all economists – and
retailers – agree with that statement.
• However, measuring these exogenous
shifts is often quite difficult, and
economists have not been successful in
anticipating these shifts.
Which is More Important –Income
or Credit ?
• Both real disposable income and the cost and
availability of credit are key determinants of
consumer spending.
• Most short-term fluctuations in consumption are
related to changes in credit rather than income.
• Temporary changes in tax rates do not affect
consumption very much. Permanent changes
are more likely to affect spending in the longer
term.
Impact of Consumer Confidence
• Many business managers use the index of
consumer confidence as a useful shorthand for
how much consumers will spend in the near
future.
• The key determinants are:
• Level of the unemployment rate
• Change in unemployment rate
• Change in rate of inflation
• Change in stock market
• Change in implicit wage rate (a measure of
overtime and “good jobs”).
How Useful Is It?
• The index of consumer confidence accurately
tracks the major changes in the ratio of
consumer spending to income.
• However, short-term fluctuations in this index,
which are often tied to exogenous events such
as wars, elections, and natural disasters, are not
reflected in changes in consumer spending.
• Conversely, very short-term changes in
consumer spending often appear to be random
in nature (weather, etc.) and are not tied to
either economic or attitudinal variables.