2.2.2 Consumption (Edexcel)

Question 1

What are influences on consumer spending?

Answer 1

Question 2

What is disposable income?

Answer 2

Disposable income is the income left over for an individual or household after taxes have been paid. It is a crucial determinant of consumer spending.

Question 3

What is the Relationship Between Disposable Income and Consumer Spending?

Answer 3

• Generally, as disposable income increases, consumer spending tends to rise.
• This relationship is explained by the marginal propensity to consume (MPC), which is the proportion of an additional dollar of income that a consumer spends.
• If MPC is 0.8, it means that for every additional dollar of disposable income, the consumer will spend 80 cents and save 20 cents.
• Real-World Example: During an economic downturn, people may experience a decrease in disposable income due to job losses. This can lead to a reduction in consumer spending, negatively impacting businesses.

Question 4

What is the relationship between savings and consumption?

Answer 4

• Savings are the portion of income that is not spent on consumption. There is an inverse relationship between savings and consumption:
• When consumers save more (increase savings), they spend less on consumption.
• When consumers save less (decrease savings), they spend more on consumption.
• Real-World Example: During economic booms, people often feel more financially secure and may reduce their savings rate, leading to increased consumer spending on items like luxury goods, travel, and dining out.

Question 5

How do interest rates affect consumer spending?

Answer 5

• Interest rates affect both the incentive to save and the cost of borrowing
• Higher interest rates make it more expensive to borrow and raise the incentive to save, therefore consumer spending will fall
• Lower interest rates tend to stimulate consumer spending because borrowing costs are reduced.
• For example, when mortgage interest rates are low, more people may buy homes, leading to increased spending on furniture and home-related goods.

Question 6

How does consumer confidence affect consumer spending?

Answer 6

Consumer confidence reflects the optimism or pessimism of consumers about the future of the economy. Uncertainty causes spending to fall.
Higher consumer confidence generally leads to increased consumer spending, as people are more willing to make major purchases when they believe the economy is doing well.

Question 7

How does wealth effects affect consumer spending?

Answer 7

The wealth effect is when a rise in wealth can increase consumer demand. This can be due to:
- Rising wealth leading to rising confidence
- Positive equity – if household spending rises, then they could ‘release more equity’ from their assets
e.g. remortgaging, to pay off any debts that they might incur
* Conversely, during a financial crisis, declining asset values can lead to reduced consumer spending.
* Real-World Example: During the housing market bubble in the mid-2000s, rising home prices made many homeowners feel wealthier. This increase in perceived wealth contributed to higher consumer spending on items like home improvements and luxury goods.

Question 8

What is Consumption?

Answer 8

Consumption (also known as consumer spending) is spending on consumer/household goods & services

Question 9

What are the main sources of incomes for households?

Answer 9

The main sources of incomes for households are wages, savings, interest on investments, pensions and
benefits

Question 10

Income comes from providing factors of production. What are the rewards for providing these factors of production?

Answer 10

• The reward for providing labour = wages
• The reward for providing land = rent
• The reward for providing capital = interest
• The reward for providing entrepreneurship = profit

Question 11

What is the biggest component of AD?

Answer 11

• Consumption is the biggest component of UK aggregate demand as it is in many countries

Question 12

What is the marginal propensity to consume?

Answer 12

the proportion of additional income
that is spent

Question 13

Give an example of MPC.

Answer 13

• Say that someone receives extra pay of £2000 and they spend £1500
• Thus, the marginal propensity to consume is £1500 / £2000 = 0.75
• The remainder is saved, so the marginal propensity to save is 0.25

Question 14

What is animal spirits?

Answer 14

Animal spirits is a term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe the instincts, proclivities and emotions that ostensibly influence and guide human behaviour.

Question 15

What is debt financing?

Answer 15

Debt financing means borrowing money from an outside source with the promise of paying back the loan, plus interest, at a later date. Lending is either secured or unsecured.

Question 16

What is a secured loan?

Answer 16

Money you borrow that is secured against an asset you own, usually your home

Question 17

What is a unsecured loan?

Answer 17

Money supported only by a borrower’s creditworthiness (rather than by any type of
“collateral”)

Question 18

As a real world example, explain what happened to household debt in the UK?

Answer 18

Total household debt in the UK rose sharply from the late 1990s up until the financial crisis began in 2008. Debt as a proportion of household income rose from 85% in 1997 to 148% at its peak in early 2008 (the total amount of household debt went up from £500 billion to £1,450 billion over this time). During the recession of 2008/09, banks were much more reluctant to lend money and consumers were less inclined to take on credit, with some focusing on paying off existing loans during difficult economic conditions. As a result, the household debt-to-income ratio fell to 127% by late 2015. Starting in early 2016, growth in household debt levels accelerated, leading to the debt-to-income ratio to increase from 127% in 2015 to 133% in 2018.

Question 19

What is saving?

Answer 19

Saving is household disposable income (Yd) that is not spent i.e. it is deferred spending. In a simple, closed economy, we can say that Yd = C + S

Question 20

What is a simple economy?

Answer 20

A simple economy is one that has no government (i.e. no tax/government spending) and a closed
economy is one that has no trade (i.e. no exports and imports)

Question 21

What does the savings ratio measure?

Answer 21

The saving ratio for households measures the amount of money households have available to save as a
percentage of their total disposable income; we can also call this the average propensity to save (APS)

Question 22

Describe what the savings gap between households in the UK was like.

Answer 22

Low-income families had just £95 of savings and investments, excluding pensions in 2016. This figure jumps to £62,885 among high-income families. (Source: Aviva)

Question 23

What is the household savings ratio?

Answer 23

The household savings ratio estimates the amount of money households have available to save, measured as a percentage of their total disposable income.

Question 24

What are the key factors that affect household saving?

Answer 24

Question 25

List the reasons for the importance of saving

Answer 25

• Business survival
• Funding investment
• Buffer of financial resources for consumers

Question 26

Explain why saving is important for business success

Answer 26

• Corporate savings provide a cushion during a recession when sales and revenues are falling
• Business savings can be used as finance for takeovers and also for capital investment projects

Question 27

Explain why saving is important for funding investment

Answer 27

Commercial banks need savings deposits from which they can lend to borrowers
Savings flow into pension funds - these can be reinvested in stock markets providing investment funds

Question 28

Explain why saving is important as a buffer of financial resources for consumers

Answer 28

• Savings can smooth consumption during tough economic times
• They allow people to reduce their debts
• Savings are a key source of retirement income i.e. they help to smooth consumption over one’s life Savings allow households to purchase ‘big ticket items’ e.g. expensive items such as household appliances
• Savings also allow households to build up deposits to put towards a house purchase (it is usually only possible to take out a mortgage i.e. a loan for purchasing a house, if a certain proportion of the house price is paid upfront)