"Consumption is determined by Income"

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“Consumption is determined by income”

by Ben Sharp

“Consumption is determined by Income”

        Consumption is defined as consumer spending on goods and services over a certain period of time. In this case, disposable income is used as this is the aggregate amount of money a person earns during a given period. There are a number of factors which determine how much a household consumes. The relationship between consumption and these factors is called the consumption function. The most important factor of consumption is disposable income but other factors can bring around significant changes in consumption.

One factor of consumption is the amount of wealth a household has. A household is constituted of the general public as distinct from a firm or business. In common parlance the general public is often called consumers Wealth is made up of physical wealth and monetary wealth. Physical wealth is durable items such as cars, houses and furniture whereas monetary wealth is made up of cash, shares and pension rights. If the wealth of a household increases then consumption is expected to increase, this is known as the wealth effect.

Another factor of consumption is inflation. This increases the general level of prices and has two effects on consumption. Firstly, if households expect prices to be higher in the future then they will be tempted to bring forward their purchases. Thus a household’s anticipation of inflation can increase consumption and reduce saving. However, this may be outweighed by the effect of inflation on wealth. Rising inflation tends to erode the real value of monetary wealth. Households react to this by trying to save as much as possible and so consumption is reduced. The negative effect of inflation on consumption caused by the eroding of real monetary wealth more than offsets the positive effect on consumption caused by earlier purchases.

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Much of the money to buy durables, e.g. cars, comes from credit finance and so an increase in the rate of interest increases the monthly payments for these goods. This means that, effectively, the price of the goods has increased. Households react to this by reducing their demand for durables and so cutting their consumption. Many households also have borrowed money to purchase houses. Increased interest rates lead to increased mortgage repayments. Again, this will reduce the amount of a household’s disposable income thereby directly cutting the spending on payments for other items and, perhaps, more importantly, discouraging households from ...

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