2.2.2 Consumption

Question 1

Why does the real balance effect cause AD curve to slope downwards?:

Question 2

Disposable income

Answer 2

the income that an individual receives after having paid any direct taxes and received any transfer payments/benefits
- we expect there to be a positive relationship between disposable income and consumption

Question 3

Relationship between consumption and savings

Answer 3

as consumers save more, they spend less

Question 4

Influence of interest rates on consumption

Answer 4

• interest rates rise, consumers have more incentive to save
• the cost of buying credit rises and interest payments on any variable rate/loans/mortgages already taken out will rise, reducing consumers’ discretionary income
• a fall in average house prices

Question 5

Why does rise in interest rates cause a fall in average house prices?

Answer 5

as demand for houses falls because of the increased cost of taking out a mortgage

Question 6

Why do consumers have more incentive to save as interest rises?

Answer 6

as the return on saving rises so they tend to substitute saving for spending

Question 7

How does a fall in average house prices affect consumption?

Answer 7

as demand for houses falls because of the increased cost of taking out a mortgage creating a negative wealth effect in the economy

Question 8

Influence of consumer confidence on consumption

Answer 8

If they are worried about losing a job/confident that shares and house prices are growing/saving because of worries about a small pension

Question 9

Influence of wealth on consumption

Answer 9

• actual changes in the economy (e.g rises in the FTSE or in average house prices) can cause real spending increase if people decide to trade in their increased wealth or may simply increase confidence in spending
• falling house prices might cause people to reduce spending

Question 10

Marginal propensity to consume formula

Answer 10

change in consumption / change in income (for individuals)

Question 11

Average propensity to consume formula

Answer 11

consumption/income

Question 12

Saving

Answer 12

disposable income that is not consumed in a given time

Question 13

Savings

Answer 13

an accumulation of all past saving

Question 14

Stock concept

Answer 14

built up over time

Question 15

Flow concept

Answer 15

what takes place over a set time period ie a year

Question 16

Wealth

Answer 16

an accumulation of all unspent or invested income (builds up- stock)

Question 17

Income

Answer 17

money received (earned) in a set time period (flow)

Question 18

Government debt

Answer 18

debt from all previous years accumulated (builds up- stock)

Question 19

Government deficit

Answer 19

what they have spend over what they have in a set time period (flow)

Question 20

Factors affecting consumption activity

Answer 20

• income
• consumer confidence
• interest rates
• young vs old
• house prices
• inflation
• wealth

Question 21

Factors affecting consumption activity (consumer confidence)

Answer 21

• Animal spirits
• economic uncertainty = decreased consumption

Question 22

Factors affecting consumption activity (interest rates)

Answer 22

• influence MPS
• decreased interest rates = decreased incentive to save = increased demand for borrowed money

Question 23

Factors affecting consumption activity (interest rates) evaluation

Answer 23

Depends on economic cycle/confidence

Question 24

How does income affect consumption?

Answer 24

higher income = more disposable income = more confidence = spend more

Question 25

How does young people affect consumption?

Answer 25

more young people = more confidence

Question 26

What is the impact of the MPC cutting interest rates?

Answer 26

• Lower interest rates = cheaper to borrow = encourage consumer spending.
• Cheaper borrowing = encourages firms to invest
• With an increase in C + I, = rise in AD = expect higher economic growth and higher inflation.

Question 27

Evaluation of MPC cutting interest rates

Answer 27

• in theory, lower interest rates = increase spending however commercial banks may not pass the base rate cut onto consumers.
• if other aspects of the economy are doing badly = no effect
• if cut is small. However, UK is sensitive to interest rates due to no. Available mortgages
• time lag

Question 28

Give an example of commercial banks not passing the base rate to consumers

Answer 28

• during the credit crisis, due to a shortage of cash.
• so, banks were reluctant to lend since they needed to improve their balance sheets = even though the MPC cut base rates in 2008-09, consumers may not notice lower interest rates = there was little if any increase in consumer spending.
• This explains why the interest rate cut of 2009, failed to cause a strong economic recovery.

Question 29

Give an example of other factors offsetting the impact of low interest rates

Answer 29

• falling house prices are causing a decline in consumer wealth and confidence.
• also in 2009-11, we experienced a global recession.
• The recession in the Eurozone caused lower exports = the cut in rates could be insufficient given the fact other aspects of AD are being reduced.

Question 30

Why might the UK be sensitive to interest rates?

Answer 30

• the UK is sensitive to interest rates because of the number of variable mortgages.
• Even a 0.25% cut in rates can increase disposable income for people with large mortgages

Question 31

What is the impact of high income on the marginal propensity to save?

Answer 31

• for high income earners = reduces marginal propensity to save
• for low income earners = increases marginal propensity to save

Question 32

Why might demand for a good might increase even when consumer ‘incomes fail to keep up with inflation’?

Answer 32

• they are inferior goods (but some consumers might value quality over price)
• cheaper compared to substitutes (however size of substitution effect might be low if consumer’s perceive the inflation change to be temporary)