2.2.2 - Consumption

Question 1

Define Consumption

Answer 1

Total spending by households on good and services in the economy

E.g. Buying car, buying chocolate

Question 2

Name two types of Good

Answer 2

. Durable Goods are consumed over a long period of time e.g. car

. Non - Durable Goods are consumed immediately e.g. food, ice cream

Question 3

Define Disposable Income

Answer 3

. Amount of income a individual or household has to spend after taxes and bills have been deducted

Question 4

Define Marginal Propensity to Consume (MPC)

Answer 4

. The proportion of a change in income, which is spent

Change in Consumption / Change in Income

Question 5

How does Marginal Propensity to Consume (MPC) change with countries?

Answer 5

. MPC is lower at higher incomes so in HICs the MPC is likely to be low

. In LICs there is less saving and more consumption due to a lower income. This means a higher MPC. This relates to the Harrod - Domar Model.

Question 6

Define Average propensity to Consume (APC)

Answer 6

. Measures the average amount spent on consumption out of total income

Consumption / Income

. In most rich economies, APC is likely to be less than 1 because consumers will also save part of their savings

Question 7

Keynesian Theory on APC and MPC

Answer 7

.Suggested that as incomes rose, households would prefer to save more and so the average propensity to consume would decline

. Also higher income households would save a larger proportion of their income than poorer households

. Redistributing income (e.g. through taxation) from high income earners to those on low incomes would therefore increase total consumption in the economy, increasing Aggregate Demand

Question 8

Name the FIVE determinants Consumption
(These factors cause a shift in AD if price level is fixed)

Answer 8

. Level of Real Disposable Income
. Interest Rates
. Consumer Confidence
. Wealth Effects
. Anticipated Inflation

Question 9

Explain Level of Real Disposable Income

Answer 9

. Real Disposable Income means disposable income adjusted for inflation

. The higher the level of real disposable income, the higher the consumption

. If income tax decreases in the economy, real disposable income increases.

. This will increase the marginal propensity to consume, thus increasing consumption

Question 10

Explain Interest Rates

Answer 10

1.) A cut in the interest rates will reduce the cost to borrow. This makes it cheaper for consumers to borrow, reducing the opportunity cost of doing so. This incentivises individuals to borrow more, increasing their disposable income allowing them to spend on goods and services increasing the marginal propensity to consume

. Additionally, the rate of return of saving decreases, reducing the incentive to save with any income generated going to spending, increasing consumption

2.) Additionally, a cut in interest rates will reduce the monthly payments for those with variable rate mortgages.

. These homeowners will receive a boost to their disposable income, increasing their marginal propensity to consume thus increasing consumption in the economy

Question 11

Explain Consumer Confidence

Answer 11

1.) Consumer confidence is determined by the expectation of the future state of the economy

. If consumers foresee a boom in the economy, their confidence will rise as they stay to expect to stay in work or perhaps gain a promotion and with that a rise in income

. This will increase the marginal propensity to consume and increase consumption

2.) However, if consumers foresee a recession, their confidence falls as they predict potential redundancy.

. Low consumer confidence will lead more saving than spending as consumers prepare for financial difficulties, hence reducing the consumption in the economy

Question 12

Explain Wealth Effect / Asset Price

Answer 12

. The wealthier people feel, the more likely they are to spend money due to increased confidence and financially security; there will be a higher marginal propensity to consume

. Wealth of a households is made out of two parts: Physical and Monetary Wealth

. Physical Wealth is made out of items such as houses and cars

. Monetary Wealth is items such as cash, money in bank, stocks and shares

.The Wealth of a households can increase in two ways:

1. ) House price increases, then households feel wealthier, hence increasing their consumption. Additionally, there is increased ability to re-mortgage and take equity withdrawal. This means more disposable income, increasing the marginal propensity to consume and reduces the marginal propensity to save, thus increasing consumption, which increases AD from AD1 to AD2.
2. ) Increase in share prices, stock prices, bonds prices can incentivise to sell these assets, which would increase the amount of disposable of income. This would increase the marginal propensity to consume, thus increasing AD from AD1 to AD2

Question 13

Name Two Types of Wealth

Answer 13

. Physical Wealth
. Monetary Wealth

Question 14

Explain Anticipated Inflation

Answer 14

1.) If consumers anticipate higher rates of inflation in the future, they may bring forwards their consumption to protect themselves from lower purchasing power in the future

. This increases immediate consumption in the economy

2.) If deflation is occurring and is anticipated, individuals will delay their spending to maximise the spending power of their income.

. This will reduce immediate consumption

Question 15

Define Saving

Answer 15

. The proportion of a household’s disposable income, which is NOT spent over a period of time

Question 16

Define Average Propensity to Save (APS)

Answer 16

. The proportion of a total income which is saved

Amount Saved / Income

Question 17

Define Marginal Propensity to Save (MPS)

Answer 17

. The proportion of a change in income which is saved

Change in amount saved / Change in Income

Question 18

Determinants of Saving

Answer 18

• Think of opposite of determinants of consumption

Examples :

. Interest rates increase : Increase marginal propensity to save and reduce the incentive to borrow and spend as the opportunity of borrowing increases. As a consequence, the saving ration in economy will increase with less consumer spending taking place.

. Consumer confidence : Low consumer confidence increase the marginal propensity to save and decreases the marginal propensity to consume due to the prospect of redundancy.

• NOTE : Using words like increase / decrease propensity to save / consume

Question 19

Relationship between savings and consumption

Answer 19

. Generally, as consumers save more, they spend less, and vice versa.