Disposable income and spending – the propensity to spend

John Maynard Keynes was undoubtedly one of the major figures in the history of economics developed a theory of consumption that depended mainly on disposable income. Disposable income is income after direct taxes and welfare benefits.

The Marginal Propensity to Consume

The marginal propensity to consume is thechange in consumer spending arising from a change in disposable income.

If for example your disposable income rises by £5,000 and you choose to spend £4000 of this on extra goods and services, then the MPC is £4000/£5000 or 0.8

A simple rule to remember is that the marginal propensity to consumer added to the marginal propensity to save must always equal 1.

Generally, people on lower incomes tend to have a higher propensity to spend. This matters when the government announces changes in taxation and the level of welfare benefits. A fall in the marginal propensity to spend will cause a lower level of consumption for a given level of income.

Key factors influencing consumer spending

• Changes in real disposable incomes (Yd) for households e.g. from changes in direct taxes and state welfare payments
• Level of and changes in employment & job security
• Availability and cost of consumer credit – affects willingness to borrow
• Costofservicing a mortgage (i.e. monthly interest payments)
• Changes in asset prices such as property and shares – possible wealth effect
• Expectations of futurepricechanges e.g. if there is persistent price deflation
• General state of consumer confidence / pessimism (“animal spirits”)

Consumer confidence

Consumer confidence surveys measure changes in consumer attitudes, including expectations of the economic situation and households’ own financial positions, and their views on making major purchases such as a new car or spending on expensive home improvements. When consumer confidence is low people save more because of fears about job security and future income.

The Wealth Effect

• Wealth represents the value of a stock of assets
• For most people the majority of their wealth is held in property, shares in quoted companies on the stock market, savings in banks, building societies and money building up in occupational pension schemes
• Many economists think that there is a positive relationship between wealth and spending although the size of the effect is open to question.

• For millions of people, assets in the form of savings and occupational pension schemes are important. So the real value of their savings and the income that flows from deposit accounts from interest payments will have a direct effect on their spending power.
• In recent years the average rate of interest on UK savings deposits have less than the rate of inflation – causing a cut in the real purchasing power of savers

Consumer borrowing

Most of us at some time in our lives need to borrow money to finance spending. The credit market for individuals is complex. Broadly speaking we can distinguish between:

• Unsecured borrowing – that is a loan or an overdraft which is not tied to the value of another asset. Examples of this are student overdrafts, bank loans and money borrowed on store and credit cards
• Secured borrowing – is lending where the borrower must use another asset as collateral for the loan. The best example of this is a mortgage with a bank or building society. Home buyers are at risk if they fail to keep up with monthly mortgage repayments and ultimately, the lender may foreclose and seek repossession of the property.

Consumer spending - key terms

• Base interest rate: Set by the Bank of England, it is the rate of interest used by commercial banks as the basis for their own lending rates.
• Consumer confidence: Expectations about the future including interest rates, prices, incomes and jobs.
• Disposable income: Income after the deduction of direct taxes and addition of welfare benefits.
• FTSE-100 Index: The FTSE-100 tracks share-prices of the 100 largest companies listed on the London Stock Exchange.
• Savings ratio: The ratio of personal saving to household disposable income (usually expressed as a percentage).