This article defines consumption and saving as well as introduces The Average Propensity to Consume (APC) and The Marginal Propensity to Consume (MPC).
It also explains the determinants of consumption and saving including wealth, inflation and expectations, interest rates, availability of credit, TAXation, unemployment and technological development.
Basics of consumption and saving
Consumption is consumer spending on goods and services over a period of time. Whilst saving is simply income which is not spent and usually saved in banks.
Naturally, both savings and consumption are related through the idea of opportunity cost. If we spend money, we cannot save it. And, if we do not spend money, we can save it.
There are two calculations that show this relation within an economic system:
- Average Propensity to Consume (APC)
- Marginal Propensity to Consume (MPC)
Propensity means the inclination or preference to do something.
1. Average Propensity to Consume (APC)
Average Propensity to Consume (APC) is that part of income that is spent on consumption.
Average Propensity to Consume (APC) = Consumption (C) / Income (I)
When total disposable income in an economy is USD$100 billion and consumption is USD$80 billion, then Average Propensity to Consumer (APC) equals to 0.8.
2. Marginal Propensity to Consume (MPC)
Average Propensity to Consumer (MPC) is the ratio of change in consumption spending to change in total income, or what proportion of change in income is spent on consumption.
Marginal Propensity to Consume (MPC) = Change in Consumption (∆C) / Change in Income (∆I)
In the following year, when total disposable income increases to USD$110 billion and consumption increases to USD$85 billion, then Marginal Propensity to Consumer (MPC) equals to 0.5.
It is quite normal for Marginal Propensity to Consumer (MPC) to be between 0 and 1, since as people earn more, it is only natural that they also consume more. However, it is possible for Marginal Propensity to Consumer (MPC) to be more than 1 for an individual household, if they are supplementing consumption with borrowing. Suppose a household supports the large purchase of a durable good, such as a car, with borrowing, such as a loan.
The list of determinants of consumption and saving
There are many factors which affect our ability and decisions regarding consumption and saving. These determinants include the following:
- Wealth.
- Inflation and expectations.
- Interest rates.
- Availability of credit.
- TAXation.
- Unemployment.
- Technological development.
Main factors that determine consumption and saving
1. Wealth
There are two types of wealth – monetary wealth and physical wealth. Monetary wealth is made up of cash, money in the bank, investments in stocks, etc. Physical wealth is made up of property and belongings such as houses, TVs, cars, furniture, etc.
The Wealth Effect is a term used to refer to the fact that an increase in the wealth of a household will cause an increase in consumption. With more wealth, people can offer more as collateral, for example their home or land parcel.
The Wealth Effect is commonly associated with an increase in the value of shares of stock as people can sell them earning capital gain and then spend the profits as well as an increase in housing prices as this increases people’s ability to borrow.
2. Inflation and expectations
Inflation means the gradual increase of prices in an economy over time.
If households anticipate a sharp increase in prices later, they will bring forward their purchases buying sooner rather than later. For example, every year the UK government makes it fiscal policy known in the publicly published Budget Report. This gives details, for example, of TAXation increases for demerit goods including petrol, cigarettes, beer and spirits. When people see that the price of cigarettes is going to rise, they will purchase in advance of the price increase.
Although this causes an increase in consumption, inflation will grow too. And growing inflation will have a negative effect overall because inflation reduces the value of savings. This can be called the erosion of wealth. The real value of money saved in the bank will decrease with inflation. Some households, particularly those who are older, will increase the percentage of income they save. They may do this in the hope of maintaining the value of their money, so that they can have a more comfortable retirement.
Expectations can also have a wider context. Expectations simply refer to whether or not consumers have a positive or negative view of the future of the economy, so called consumer confidence. Positive views will lead to greater consumption while negative views will lead to lower consumption.
3. Interest rates
Households borrow money to pay for consumer durables such as cars, furniture, flat-screen TV’s and of course houses and apartment. An increase in interest rates will increase the cost of borrowing, so fewer households will be willing to take bank loans. They either cannot afford the repayments, or they are fearful of losing some of their wealth when they find themselves unable to return the money. So, the result of an increase in interest rates is a decrease in consumption of durable products.
Additionally, an increase in the interest rate will raise the cost of mortgages which are long-term bank loans for purchasing property. This will reduce the amount of disposable income that consumers have to spend on goods and services as now monthly repayments will be higher.
Another important factor is that higher interest rates increase the value of savings encouraging households to save more of their income. Naturally, the reverse is true. A decrease in interest rates reduces the cost of borrowing and the value of savings, thus encourages more consumption and less saving.
4. Availability of credit
Governments can intervene in markets in two ways to discourage or encourage spending by regulating or deregulating credit.
If the government feels that the economy is overheating (demand is too high and inflation is out of control), it may want the economy to cool down. This can be done by limiting the amount that may be borrowed and limiting the number of repayments or time allowed (maximum repayment period). These actions will result in a reduction in consumption.
On the other hand, lifting these restrictions will cause consumption to increase.
If the government feels that the economy is not growing fast enough (demand is too low and unemployment is high), it may want the economy to expand. This can be done by increasing the amount that may be borrowed and increasing the number of repayments or time allowed (maximum repayment period). These actions will result in higher consumption.
Other factors that determine consumption and saving
5. TAXation
Decreases in TAXation will lead to an increase in overall consumption in the economy.
Increases in TAXation will lead to a decrease in overall consumption in the country.
6. Unemployment
A decrease in unemployment will lead to an increase in consumption as more people will have jobs and earn income.
An increase in unemployment will lead to a decrease in consumption as less people will have jobs hence no income.
7. Technological development
In general, technology creates new products which motivates consumers to spend, and so increases consumption; e.g. smart phones, laptop computers, high-definition TV, electric cars, solar panels, smart homes, etc.
Summary about consumption and saving
Consumption means spending. This is connected with many economic variables including wealth and income, inflation and interest rates, the availability of credit and TAXation, unemployment and future expectations as well as technological development.
Saving is a part of consumption because we save money with future consumption levels in mind.
