AS Macroeconomics / International Economy

Consumer Spending and Saving

Consumption accounts for 65% of aggregate demand. There are many factors that affect how much people are willing and able to spend. It is important to understand these factors because changes in consumer spending have an important effect on path of the economic cycle.

John Maynard Keynes developed a theory of consumption that focused primarily on the level of people’s disposable income in determining their spending. The rate at which consumers increase demand as income rises is called the marginal propensity to consume. For example if someone receives an increase in income of £2000 and they spend £1500 of this, the marginal propensity to spend is £1500 / £2000 = 0.75. The remainder is saved – so the propensity to save would be 0.25.

The marginal propensity to spend and to save differs from person to person. Generally, people on lower incomes tend to have a higher propensity to spend. This has important implications when the government announces changes in direct taxation and the level of welfare benefits.

Incomes matter in determining spending

The key factors that determine consumer spending in the economy can be summarized as follows:

• The level of real disposable household income
• Interest rates and the availability of credit
• Consumer confidence
• Changes in household financial wealth
• Changes in employment and unemployment

The strength of consumer spending has been one of the main reasons why Britain has avoided a recession in recent years – but at the same time, there are fears that household spending has been too high, and that much of it has been financed by a surge in borrowing leading to record levels of household debt. One key reason for this has been the strength of the housing market which has allowed millions of home-owners to borrow extra money secured on the value of their property. This is known as mortgage equity withdrawal. A large percentage of this demand has also fed into demand for imported goods and services, causing a sharp increase in the UK’s trade deficit with other countries.

Spending on consumer durables

Consumer durables are items that provide a flow of services to a consumer over a period of time. Examples include new cars, household appliances, audio-visual equipment, furniture etc. The real level of spending on durables has surged in the last eight years.

Among the explanations are

• Falling prices for many durable products – arising from rapid advances in production technology and the effects of globalization which means that we can now import many of these durables more cheaply from overseas
• Low interest rates which have encouraged people to spend more on “big ticket items” – there has been a surge in demand for consumer credit
• Strong consumer confidence and borrowing levels. The demand for consumer durables is more income elastic than for non-durables which are usually staple items in people’s monthly budget.

The Wealth Effect

Wealth represents the value of a stock of assets owned by people. For most people the majority of their wealth is held in the form of property, shares in quoted companies on the stock market, savings in banks, building societies and money accumulating in occupational pension schemes.

There is a positive wealth effect between changes in financial wealth and total consumer demand for goods and services. For example when house prices are rising strongly, consumer confidence grows and home-owners can also borrow some of the equity in their homes to finance major items of spending.

The Savings Ratio

Saving represents a decision to postpone consumption by saving money out of disposable income. Why do people choose to save their incomes? There are many motivations for saving:

• Precautionary saving: People might save more because of a fear of being made unemployed. A nest egg of savings allows people to smooth their spending even when incomes are fluctuating.
• Building up potential spending power: Saving more now is a choice to defer spending today to finance major spending commitments in the future (e.g. saving for the deposit on a mortgage, a new car or a wedding). People are also becoming increasingly aware of the need to save in order to build up assets in occupational pension schemes because of fears that the relative value of the state retirement pension will fall in the years ahead.
• Interest rates and saving: There might be a greater willingness to save because of the incentives of high interest rates from banks, building societies and other financial institutions.
• Inheritance: Many people have a desire to pass on bequests of wealth to future generations.
• Saving and the life-cycle of consumers: Younger people are often net borrowers of money because they need to fund their degrees, purchase a property and expensive consumer durables. As people grow older, their incomes from work tend to rise and their spending commitments decline leading to an increase in net saving ahead of retirement.

 
The savings ratio

The household savings ratio is the level of people’s savings as a percentage of their disposable income. The savings ratio was high during the early 1990s as a result of the high levels of unemployment and also high interest rates. In recent years there has been a fall in the savings ratio in part because consumer borrowing has reached record levels, fuelled in part by the rapid acceleration in house prices. At some point the savings ratio will need to rise again as people rein back on their spending in order to repay debts on credit cards and other forms of secured and unsecured borrowing. We have started to see a gradual rise in the savings ratio during 2005 and the first half of 2006.

The importance of consumer confidence

The willingness of people to make major spending commitments depends on how confident they are about both their own financial circumstances, and also the general state of the economy. Consumer confidence is quite volatile from month to month. Some of the fluctuations are seasonal – but the underlying trend is what really matters. One interesting aspect of recent data is that people have remained more optimistic about their own financial situation than they have about prospects for the UK economy as a whole. This perhaps helps to explain why people have continued to be prepared to make big-ticket purchases on new consumer durables (many of which have been imported).

The main factors affecting consumer confidence are summarised as follows:

• Expectations of future income and employment
• The current level of interest rates and expectations of future interest rate movements
• Trends in unemployment and changes in perceived job security
• Anticipated changes in government taxation
• Changes in household wealth including movements in house and share prices

The consumer borrowing boom of recent years

The British economy has seen high consumer borrowing in recent years. This has been the result of a number of factors summarised below:

• Low unemployment – has led to rising consumer confidence.
• Strong growth of house prices – has encouraged mortgage equity withdrawal.
• Expectations of rising real incomes – people have expected their incomes to rise each year as pay levels have grown more quickly than inflation.
• Low interest rates – reducing the opportunity cost of borrowing money.
• Falling prices of consumer durables – many of which are bought using credit.

Strong demand for loans has boosted consumer spending and helped to keep the UK economy growing at a time of global uncertainty. Borrowing has also contributed to the rising trade deficit in goods and services. By the summer of 2006, the consumer borrowing boom appeared to be coming to an end. The slowdown in credit demand has been the result of a number of factors:

• Rising interest rates – the Bank of England has been raising interest rates from 3.5% to 4.75% – this has helped to curb demand for new loans (interest rates currently at 4.5%).
• Weakness in the housing market and fears of a possible fall in average house prices which may expose homeowners to a high level of mortgage debt.
• Unemployment has started to edge higher and more people now expect rising unemployment, expectations of what might happen tomorrow affects our behaviour today!
• The consumer debt mountain has reached high levels – well over £1 trillion – and many people are now scaling back their borrowing and saving more as a precaution against a future downturn.
• Possible consumer satiation – how many plasma TV screens or digital cameras do you need? There are limits to how many consumer durables people need to buy!

Consumer spending and the UK balance of payments

Consumers in Britain have a high marginal propensity to import goods and services so that, when their real incomes are rising and their spending increases, so too does the demand for imports. Unless there is a corresponding increase in UK exports overseas, then the balance of trade in goods and services will move towards heavier deficit. This has been the case in the UK over the last five or six years. In the medium term if demand for imports rises and the level of import penetration into the domestic economy continues to rise, then national output and employment will weaken and this will work its way through the circular flow to reduce real incomes. Living standards are reduced in the long run if our export industries are unable to compete with output produced in other countries.