Chapter 4

The Consumption Function

 Principal Determinants of
Consumption (Slide 1)
Recent average disposable income (DI)
Expected average DI
Changes in income tax rates
Cost and availability of credit
Demographic factors and age distribution
of consumers
 Principal Determinants of
Consumption (Slide 2)
Expected rate of return on assets: debt,
equity, and real estate
Changes in spendable income not
included in DI caused by fluctuations in
asset prices
Exogenous shifts in consumer attitudes
not related to any of the above variables
 Recent Average Disposable
Income (DI)
Income from All Sources
Wages, Income from Capital, and Transfer
payments
Income and social security taxes are
deducted, but not sales and excise taxes
Some income is not included, primarily
from capital gains and home refinancing
 Expected or Average DI
Most people base their spending on average or expected
income, rather than the most recent paycheck. This is
usually known as the permanent income hypothesis.
A few examples:
You win the lottery, but you dont spend all of it that
month.
You become unemployed, but your consumption doesnt
drop to zero.
You save in anticipation of the childrens college
education, then dissave during the years they are
actually in college
 Changes in Income Tax Rates
This remains a politically charged issue, but
most economists agree that:
A permanent change in tax rates has a larger
impact on consumption than a temporary
change.
Consumers are likely to spend a larger
proportion of any tax cut if they are optimistic
about the future
It is possible that while consumption rises
because of a tax cut, imports also rise, so the
net effect on real GDP is much smaller.
 Demographic factors and age
distribution of consumers
The Life Cycle Hypothesis states that young
people will dissave when they are just
starting their careers, will maximize their
saving rate shortly before retirement age,
and then dissave again during retirement
years.
That implies that the general aging of the
population would reduce the personal saving
rate.
 Cost and Availability of Credit
A key determinant, especially with the
proliferation of credit cards, home equity
loans, and other sources of borrowing.
Imposing actual credit controls has an
immediate and drastic impact on
consumer spending, but for that very
reason probably would not be utilized
again except in extreme circumstances.
 Excessive Credit Sensitivity
The PIH and LCH state that when income
declines, consumption does not decline as
much. Hence the personal saving rate would
decline in recessions
However, we find empirically that the saving rate
rises during recessions.
This is usually referred to as excessive credit
sensitivity. Even if consumers plan to spend
based on their permanent income, they may
have to cut back if borrowing sources are
diminished. This applies mainly to purchases of
durable goods.
 Cost of Credit
Five possible reasons why the personal saving
rate is positively correlated with interest rates.
When interest rates rise, people save more now
so income and consumption can be higher later.
Average monthly payment rises, reducing
demand.
Stock market declines
Housing prices rise less rapidly, so less home
equity financing and refinancing
Yield spread narrows, so credit availability
diminishes.
 Expected Real Rate of Interest
Argument is complicated by fact that when
interest rates rise, it is usually because inflation
rises, so the expected real rate of interest may
not increase.
Suppose interest rates went from 5% to 15% at
the same time that inflation went from 2% to
12% (as in the late 1970s). People would have
no additional incentive to save.
As a result, this is the weakest empirical link
between interest rates and the saving rate.
 Cost of Time Payments
This applies mainly to purchases of motor
vehicles.
Higher interest rates raise the monthly time
payment or lease payment substantially.
Zero interest rate financing boosted motor
vehicle sales sharply even though the average
reduction in the monthly payment was only
about 2%, since low interest rates enabled
manufacturers and dealers to absorb some
losses on existing leases when consumers
bought new motor vehicles.
 Changes in Stock Market
Of course stock prices depend on many
factors other than interest rates, yet it is true
that lower interest rates will lead to higher
stock prices, ceteris paribus.
Since a rising stock market boosts
consumption relative to disposable income,
there is a positive correlation between the
saving rate and interest rates for this reason.
 Impact on Housing Financing
Housing prices show a strong negative
correlation with interest rates.
As rates decline, housing prices rise faster, so
more homeowners can cash out some of this
increased equity.
Lower interest rates also permit more people to
refinance, hence reducing their monthly
mortgage payment which is not counted as
part of consumption and increase purchases
of other goods and services.
 Yield Spread
The yield spread between long and short-term
interest rates is a major determinant of
consumer spending and total GDP.
Usually, long-term rates are higher than short-
term rates. However, when the reverse is true
known as an inverted yield curve the U.S.
economy has always headed into a recession
the following year.
When the yield spread becomes inverted, banks
will reduce the amount of loans made to
consumers, hence diminishing purchases.
Expected rate of return on assets:
debt, equity, and real estate
If consumers expect the rate of return on
assets to rise, they will generally spend a
higher proportion of their income. That is
particularly true for housing, where rising
prices cause many people to cash out
some of their increased equity.
A rising stock market generally leads to an
increase in the ratio of consumption to
disposable income
 Changes in spendable income caused by
fluctuations in asset prices not included in DI
This has become an increasingly important
factor in recent years. Capital gains are not
included in disposable income even if they are
realized. Thus during a rising stock market, part
of the reported decline in the personal saving
rate could be due to an increase in realized
capital gains.
Also, many people cash out some of their
increased equity when housing prices rise.
When interest rates decline, homeowners may
refinance, hence boosting the amount of income
they have to spend on other items.
Exogenous shifts in consumer attitudes not
related to any of the above variables
Consumers will spend a higher proportion
of their income if they are optimistic about
the future, and spend less if they are
pessimistic. Virtually all economists and
retailers agree with that statement.
However, measuring these exogenous
shifts is often quite difficult, and
economists have not been successful in
anticipating these shifts.
 Which is More Important Income
or Credit ?
Both real disposable income and the cost and
availability of credit are key determinants of
consumer spending.
Most short-term fluctuations in consumption are
related to changes in credit rather than income.
Temporary changes in tax rates do not affect
consumption very much. Permanent changes
are more likely to affect spending in the longer
term.
Impact of Consumer Confidence
Many business managers use the index of
consumer confidence as a useful shorthand for
how much consumers will spend in the near
future.
The key determinants are:
Level of the unemployment rate
Change in unemployment rate
Change in rate of inflation
Change in stock market
Change in implicit wage rate (a measure of
overtime and good jobs).
 How Useful Is It?
The index of consumer confidence accurately
tracks the major changes in the ratio of
consumer spending to income.
However, short-term fluctuations in this index,
which are often tied to exogenous events such
as wars, elections, and natural disasters, are not
reflected in changes in consumer spending.
Conversely, very short-term changes in
consumer spending often appear to be random
in nature (weather, etc.) and are not tied to
either economic or attitudinal variables.