Consumption -The total spending by households on goods/services within the economy. Consumption is the largest component of AD making up around 60% of the AD value.
A) Disposable income and its influence on consumer spending
Disposable income is the income that an individual receives after paying all of their indirect taxes and after they have received any transfer payments i.e. the money available to the consumer to spend. For example, a decrease in income tax will give consumers more disposable income. As consumers have more income they are likely to increase their spending. This increases consumption within an economy and therefore AD increases.
B) An understanding of the relationship between savings and consumption
When consumers save more, they usually spend less (and vice versa). The marginal propensity to consume shows how much of a consumers extra income they spend and how much they save (change in consumption/change in income). For example, if consumption increases by 60p for each £1 of extra income then MPC will equal 0.6. The number 1 shows that all of a consumers extra income is spent, whereas 0 shows that all of a consumers extra income is saved.
C) Other influences on consumer spending:
A decrease in interest rates will reduce the cost of borrowing for consumers. As a result of this, they are more likely to take out loans for consumption purposes. Furthermore, a low interest rate reduces the return on savings. Therefore, consumers have less incentive to save their money, increasing the marginal propensity to consume. Another impact of lower interest rates is a reduction in the amount of interest that consumers have to pay on existing loans such as variable rate and tracker mortgages. This will leave consumers with more disposable income. Overall, these effects will lead to an increase in the total consumption within an economy, leading to an increase in AD, which is the reason why low interest rates are often adopted during times of economic downturn. An increase in interest rates can cause the demand for houses to decrease as the cost of taking out a mortgage increases. This can cause house prices to fall, creating a negative wealth effect in the economy and reducing consumer consumption.
As consumer confidence increases, so will their marginal propensity to consume. For example, if there is low unemployment within the economy due to increased economic growth, consumers will feel more secure in their current jobs. Therefore, consumers won’t save as much of their disposable income as they feel confident that they will have a regular source of income for the considerable future. This will lead to an increase in consumer consumption and therefore AD.
Changes in the economy such as an increase in house prices or an increase in share prices can make consumers wealthier. This causes consumers to become more confident financially and therefore consumers are encouraged to increase their spending. Furthermore, consumers may decide to sell their wealth (e.g. stocks) at their higher price, thus giving consumers more money to spend on goods/services. This will lead to an increase in consumption and AD.