2.2.2 Consumption (C)

2.2.2 Consumption (C)

This is the largest component of AD. To analyze it, we look at what makes people open their wallets.

A. Disposable Income

  • Definition: The amount of money households have available for spending and saving after direct taxes (Income Tax) have been deducted and state benefits added.

  • Marginal Propensity to Consume (MPC): This measures how much of an extra £1 of income a consumer spends. If you earn an extra £100 and spend £80, your MPC is 0.8.

    • Low-income households usually have a high MPC because they need to spend most of their income on essentials.

B. Savings vs. Consumption

There is an inverse relationship between the two.

  • The Savings Ratio: The percentage of disposable income that is saved rather than spent.

  • Determinants of Saving: Economic uncertainty (precautionary saving), the need to pay off debt, or saving for big future purchases (deposits).

C. Other Influences on Consumer Spending

  1. Interest Rates: * Cost of Borrowing: Higher rates make credit cards and loans more expensive, reducing "big ticket" purchases (cars, sofas).

    • Mortgages: Rising rates increase monthly payments for those on variable rates, leaving less discretionary income for other spending.

  2. Consumer Confidence: * Linked to job security. If people fear redundancy, they save more and spend less. Confidence is often influenced by the media and general economic growth.

  3. Wealth Effects:

    • Positive Wealth Effect: When asset prices (like houses or shares) rise, people feel wealthier and more confident to spend, even if their monthly salary hasn't changed. They may also engage in Equity Withdrawal (borrowing against the increased value of their home).

    • Negative Wealth Effect: A crash in house prices often leads to a sharp drop in AD.

Evaluation Tip: The "Marginal Propensity" Argument

When discussing a tax cut, always evaluate by saying: "The impact on AD depends on the MPC. If consumer confidence is low, the MPC may be low, meaning people save the tax cut rather than spending it, leading to a smaller shift in AD than expected."