Vocabulary List:
- Consumer Spending (C): The total expenditure by households on goods and services. It is a key component of Aggregate Demand (AD).
- Marginal Propensity to Consume (MPC): The fraction of additional income that a household consumes rather than saves. Formula: MPC=ΔCΔYMPC = \frac{\Delta C}{\Delta Y}MPC=ΔYΔC, where CCC is consumption and YYY is income.
- Marginal Propensity to Save (MPS): The fraction of additional income that a household saves rather than consumes. Formula: MPS=1−MPCMPS = 1 – MPCMPS=1−MPC.
- Aggregate Demand (AD): The total demand for goods and services in an economy at various price levels, including consumption (C), investment (I), government spending (G), and net exports (NX).
- Consumption Function: A relationship between consumer spending and disposable income, showing how consumption changes as income changes.
- Multiplier Effect: The concept that an initial change in spending leads to a larger overall impact on national income or output. The size of the multiplier depends on the marginal propensities to consume and save.
- Investment (I): Expenditures by firms on capital goods, such as machinery, equipment, and buildings, which contribute to future production capacity.
- Autonomous Consumption: The level of consumption when income is zero; it is often influenced by government transfers, welfare, or borrowing.
- Induced Consumption: The level of consumption that changes with changes in income.
Want to test your knowledge of Consumer Spending? Check out our AP Macro Free Response Questions on Consumer Spending and the Multiplier.
1. Introduction to Consumer Spending
- Consumer spending is a major component of Aggregate Demand (AD), representing the total spending by households on goods and services.
- Factors Affecting Consumer Spending:
- Income: The primary determinant of consumption, as higher income typically leads to higher consumption.
- Wealth: As wealth increases (e.g., from rising housing prices or stock market gains), consumers are more likely to increase spending.
- Interest Rates: Lower interest rates make borrowing cheaper and can encourage spending, particularly on big-ticket items like houses and cars.
- Consumer Confidence: Higher confidence in the economy can lead to increased consumer spending, while low confidence can result in reduced spending.
- Taxation: Lower taxes increase disposable income, which may boost consumer spending.
2. The Consumption Function
- The Consumption Function shows the relationship between consumption and disposable income. It is typically expressed as:C=C0+(MPC×Yd)C = C_0 + (MPC \times Y_d)C=C0+(MPC×Yd)where:
- C0C_0C0 = autonomous consumption (consumption when income is zero),
- MPCMPCMPC = marginal propensity to consume,
- YdY_dYd = disposable income.
- Autonomous Consumption (C0C_0C0): This represents consumption that occurs even when income is zero. For example, households might borrow or use savings to maintain a minimum level of consumption.
- Induced Consumption: The consumption that changes as disposable income changes. The Marginal Propensity to Consume (MPC) determines how much of an additional dollar of income is spent on consumption.
- If MPC=0.8MPC = 0.8MPC=0.8, then for every additional dollar of income, 80 cents will be spent on consumption, and the remaining 20 cents will be saved.
3. The Multiplier Effect
The Multiplier Effect refers to the idea that an initial change in spending (whether by the government, businesses, or consumers) will lead to a larger overall impact on the economy’s total output (GDP).
- When consumers spend money, the income received by businesses or individuals (the recipients of that spending) becomes their income. This income is then partially spent again, leading to a chain reaction of spending throughout the economy.
Formula for the Multiplier:
The size of the multiplier depends on the Marginal Propensity to Consume (MPC):Multiplier=11−MPC\text{Multiplier} = \frac{1}{1 – MPC}Multiplier=1−MPC1
Alternatively, it can be expressed as:Multiplier=1MPS\text{Multiplier} = \frac{1}{MPS}Multiplier=MPS1
where MPS is the Marginal Propensity to Save (MPS=1−MPCMPS = 1 – MPCMPS=1−MPC).
- Example: If the MPC is 0.75, then the Multiplier would be: Multiplier=11−0.75=4\text{Multiplier} = \frac{1}{1 – 0.75} = 4Multiplier=1−0.751=4 This means that for every $1 spent, the total increase in GDP will be $4.
How the Multiplier Works:
- When the government, businesses, or consumers increase spending (e.g., buying a new car or building a new school), this creates income for someone else.
- This income will be spent in turn, creating further income for others, and so on. Each round of spending is smaller than the last, due to saving.
- For example, if a government spends $100 million on infrastructure, and the MPC is 0.8, the total increase in GDP could be:GDP Increase=100 million×Multiplier of 5=500 million\text{GDP Increase} = 100 \, \text{million} \times \text{Multiplier of 5} = 500 \, \text{million}GDP Increase=100million×Multiplier of 5=500million
4. The Role of the Marginal Propensity to Consume (MPC) in the Multiplier
- The MPC determines the size of the multiplier effect. The higher the MPC, the larger the multiplier, as more of each additional dollar of income is spent, leading to more rounds of spending.
- If the MPC is high (e.g., 0.9), the multiplier effect will be larger, because more of each additional dollar of income will be spent, leading to a greater increase in national income.
- Conversely, if the MPC is low (e.g., 0.2), the multiplier effect will be smaller, as less of each additional dollar is spent, and more is saved.
5. Factors That Can Affect the Multiplier
Several factors can influence the size of the multiplier in an economy:
- The Level of Savings:
- If people save a larger portion of their income (i.e., the MPS is high), the multiplier will be smaller because less of the income generated from initial spending will be re-spent.
- The Marginal Tax Rate:
- High taxes reduce disposable income, which limits the amount of money available for consumption, thus reducing the size of the multiplier.
- Imports:
- If a large portion of increased spending is directed toward imports rather than domestic goods and services, the multiplier effect is reduced because money spent on imports does not contribute to domestic income.
- Time Lags:
- The full impact of the multiplier may take time to materialize, as spending occurs gradually rather than instantaneously.
- Consumer Confidence:
- If consumers are uncertain about the future, they may save rather than spend additional income, thus reducing the multiplier effect.
6. Application of the Multiplier in Fiscal Policy
- Governments use the multiplier effect when designing fiscal policy to stimulate or contract economic activity.
- Expansionary Fiscal Policy: The government may increase spending or reduce taxes to boost demand and increase national income. The multiplier effect can amplify the impact of these actions on GDP.
- Contractionary Fiscal Policy: In times of inflation, the government may reduce spending or increase taxes to decrease demand and reduce inflationary pressures. The reduction in spending also works through the multiplier effect but in reverse.
7. Limitations of the Multiplier
- Size of the Multiplier: The multiplier is not fixed; it varies depending on the economic environment and the specific circumstances of the economy.
- Inflationary Pressures: If the economy is at or near full capacity, the multiplier may not work as expected. Increased demand could lead to inflation rather than increased output.
- Crowding Out: If the government increases spending, it may lead to higher interest rates, which could reduce private investment, thereby reducing the effectiveness of the multiplier.
Mark is an A-Level Economics tutor who has been teaching for 6 years. He holds a masters degree with distinction from the London School of Economics and an undergraduate degree from the University of Edinburgh.