Consumption and income
Consumption (C): total planned spending by households on goods and services.
Disposable income: income left after direct taxes are deducted and state benefits are added.
Marginal propensity to consume (MPC): the proportion of any extra income that households spend.
- Disposable income is the main influence on consumption because households fund most spending from take-home pay, so there is a positive relationship: a rise in disposable income raises consumption.
- The MPC fixes how strongly that relationship works, so the same income rise lifts consumption by more when the MPC is higher and by less when households choose to save a larger share.
- If the MPC is 0.8, households spend 80p of every extra £1 of income and save the other 20p.
Consumption and saving
Saving: the part of disposable income that is not consumed.
Saving ratio: the proportion of disposable income that households save.
Marginal propensity to save (MPS): the proportion of any extra income that households save.
- Because saving is simply income that is not consumed, anything that raises saving out of a given income must reduce consumption from it, and vice versa, so the MPC and the MPS out of any extra income must sum to 1.
- Higher-income households tend to save a larger proportion of income, so their saving ratio is higher and their MPC is correspondingly lower.
Other influences
Interest rates: the cost of borrowing and the reward for saving, guided in the UK by the Bank of England's Bank Rate.
Consumer confidence: how optimistic households feel about future income and job security.
Wealth effect: the change in consumption that follows a change in the value of assets such as houses and shares.
- Higher interest rates cut consumption because borrowing becomes dearer, saving becomes more rewarding and mortgage repayments rise, leaving less to spend, as many UK households found when the Bank of England raised Bank Rate through 2022.
- Stronger consumer confidence raises consumption because households who fear job loss less will run down savings or borrow to spend, while a slump in confidence does the reverse.
- A positive wealth effect raises consumption even when current income is unchanged, because rising house or share prices make households feel wealthier and more willing to spend, whereas the fall in UK house prices during the 2008-09 recession made households feel poorer and cut back.
Is disposable income the main driver of consumption?
- It holds because disposable income is the strongest single determinant: consumption rises fairly reliably as take-home pay rises, which is why the positive income-consumption relationship is the starting point of the theory.
- But confidence and wealth can override it: in 2022 UK real incomes were squeezed by high inflation, yet spending held up for a time as households drew on savings, while a collapse in confidence can depress spending even when incomes are stable.
- On balance it depends on the time horizon: disposable income anchors consumption over the long run, but in the short run interest rates, confidence and wealth effects drive the swings.
- Link each influence back to whether it raises or lowers spending and therefore aggregate demand.
- Use the MPC to explain why the same income rise can raise consumption by different amounts.
- Do not confuse disposable income with gross income, as direct taxes and benefits change the amount available to spend.
- Remember that saving is not spending, so a higher saving ratio means lower consumption from a given income.
- What is disposable income and why does it drive consumption?
- How are saving and consumption related out of a given income?
- How do higher interest rates affect consumption, and why?
- What is the wealth effect on consumer spending?
