Influences on household spending and the consumption function

Household spending, also known as consumption, forms a major part of aggregate demand. Various factors affect how much households choose to spend, which in turn influences overall economic activity.

Key influences on household spending

• Income levels - The primary driver of spending, as higher disposable income allows households to purchase more goods and services.
• Interest rates - Elevated rates raise the opportunity cost of spending, encouraging saving instead, while lower rates make borrowing cheaper and boost consumption.
• Future income expectations - Positive outlooks on job security or wage growth can lead to increased current spending, even if actual income has not yet risen.
• Wealth effects - Greater wealth from assets like property enables households to sell items or use them as collateral for loans, supporting higher spending.
• Income distribution - A more unequal spread of income across society can reduce total consumption, as wealthier groups tend to save more of their earnings.

The consumption function

The consumption function describes the relationship between disposable income and household spending.

$C=a+bY$

Where:

• C = Consumption
• a = Autonomous consumption (spending that occurs even when income is zero)
• b = Marginal propensity to consume (MPC), the proportion of additional income spent on consumption
• Y = Disposable income

The term $a$ represents baseline spending, while $bY$ shows induced consumption that varies with income changes.

Worked example - Calculating consumption using the consumption function

If the consumption function is $C=\pounds 200+0.8Y$ and disposable income is £2,500, calculate total consumption.

Step 1: Identify the values

• Autonomous consumption ($a$) = £200
• Marginal propensity to consume ($b$) = 0.8
• Disposable income ($Y$) = £2,500

Step 2: Apply the consumption function

$C=\pounds 200+0.8\times \pounds \mathrm{2,500}$

Step 3: Calculate total consumption

$C=\pounds 200+\pounds \mathrm{2,000}=\pounds \mathrm{2,200}$

The savings function

Saving represents the portion of income not spent on consumption. The savings function illustrates how saving relates to income levels, highlighting both baseline behaviours and responses to income changes.

Formula for the savings function

$S=-a+sY$

Where:

• S = Saving
• -a = Autonomous dissaving (negative saving when income is low, representing borrowing or using past savings)
• s = Marginal propensity to save (MPS), the proportion of additional income that is saved
• Y = Income

The term $sY$ indicates induced saving that increases with income.

Relationship between average propensities

• Average propensity to save (APS) - Calculated as $S/Y$, showing the fraction of total income saved.
• Average propensity to consume (APC) - Equals $1-APS$, as all income is either spent or saved.

Worked example - Calculating saving and average propensity to save

If the savings function is $S=-\pounds 200+0.2Y$ and income is £4,000, calculate total saving and the average propensity to save.

Step 1: Identify the values

• Autonomous dissaving ($-a$) = -£200
• Marginal propensity to save ($s$) = 0.2
• Income ($Y$) = £4,000

Step 2: Apply the savings function

$S=-\pounds 200+0.2\times \pounds \mathrm{4,000}$

Step 3: Calculate total saving

$S=-\pounds 200+\pounds 800=\pounds 600$

Step 4: Calculate average propensity to save

$\text{APS}=\frac{\pounds 600}{\pounds \mathrm{4,000}}=0.15$

Factors influencing investment and the accelerator theory

Investment involves spending on capital goods to expand production capacity. It is a volatile component of aggregate demand, influenced by economic conditions and expectations.

Key factors influencing investment

• Changes in income and consumer demand - Rising demand encourages firms to invest in more equipment to meet needs.
• Interest rates - Lower rates reduce borrowing costs, making investment more attractive.
• Technological advances - New innovations can prompt investment in updated machinery for efficiency gains.
• Cost of capital goods - Lower prices for equipment or materials make investment more feasible.
• Business expectations - Optimism about future profits drives investment, while pessimism can lead to cutbacks.
• Government policies - Incentives like tax breaks or subsidies can stimulate investment spending.

Types of investment

Autonomous investment occurs regardless of income changes, often due to external factors like reduced interest rates or positive market sentiment. It shifts the overall expenditure curve upwards.

Induced investment is directly tied to income fluctuations, where firms invest more as demand grows, represented by movement along the expenditure curve.

The accelerator theory

The accelerator theory explains the volatility of induced investment, emphasising its link to the rate of change in income or consumer demand rather than absolute levels.

How the accelerator theory works:

• Investment levels respond disproportionately to changes in gross domestic product (GDP) or demand.
• The accelerator coefficient measures this effect; for instance, if it is 4, a £2 million rise in GDP could lead to a £8 million increase in induced investment.
• Steady GDP growth maintains constant investment, but accelerations or decelerations in growth cause sharp changes.
• Example: A 10% rise in demand for vehicles might trigger a 35% increase in investment for factory expansions.

Limitations of the accelerator theory

• Spare capacity - Firms may not invest if they already have unused resources.
• Demand expectations - Investment halts if demand growth is seen as temporary.
• Supply constraints - If capital goods producers are at full capacity, investment cannot increase quickly.

Determinants of government spending

Government spending contributes to aggregate demand through public services and infrastructure. It often adjusts based on economic conditions and societal needs.

Factors affecting government spending

• Economic downturns - Governments may boost spending to stimulate demand and avoid recessions.
• Market failure risks - Higher spending occurs in areas like education and healthcare where private markets may underperform.
• Technological progress - Funds are allocated for modernising public facilities or acquiring new equipment.
• Population shifts - An ageing population or increased immigration can raise spending on services like pensions or housing.
• Unexpected events - Natural disasters or military conflicts often require immediate increases in expenditure.

Influences on net exports

Net exports represent the difference between a country's exports and imports, influencing aggregate demand through international trade.

Key influences on net exports

Relative price competitiveness:

• Determined by productivity levels, where higher efficiency lowers costs and boosts exports.
• Affected by inflation rates; lower domestic inflation makes goods cheaper abroad.
• Influenced by exchange rates; a weaker currency makes exports more affordable internationally.

Quality competitiveness:

• Enhanced through investment in technology and infrastructure.
• Improved by raising educational standards to develop a skilled workforce.

Income levels at home and abroad:

• Rising foreign incomes increase demand for exports.
• Higher domestic incomes can lead to more imports.
• Goods with high income elasticity of demand see greater export growth during foreign income rises.