Chapter 10, Problem aWYWL

To determine

What factors determine how consumers spend their income?

Concept Introduction:

Many factors affect how consumers spend their income; the first of them we can say is that the propensity to consume.

Propensity to consume: The famous economist John Maynard Keynes introduced the propensity to consume, it is defined as the proportion of disposable income to the consumption or in another words how much of the income of people spend on consumption.

Disposable income: This is the income of the people after taxation.

Explanation of Solution

The first factor that determines the consumption spending is the propensity to consume; as the income of the people rises the propensity to consume will also rise. Generally rich people tend to have a high propensity to consume and poor people have a low propensity to consume. The second factor that affects the consumption spending is the real income of the people; real income of the people is after deducting the inflation. So people have a higher real income to spend more of their income and vice versa. The next factor is the interest rate in the economy, if the interest rate is low that means the people have to less on their mortgage payments, so this will raise the disposable income of the people, raise in the disposable income of the people means higher consumption from the people.

The next factor is the direct and indirect taxation in the economy, the rate of taxation directly affects the disposable income of the people. A high tax rate means low disposable income to the people so they will consume less. Another factor is the supply of credit in the economy, if there is a low supply of credit in the economy, this means people have a relatively low disposable income so they consume less, and if there is more supply of credit in the economy they will borrow more funds and they should have a higher disposable income to spend. The next factor is the demographics of the country if there is a large number of people in a country, this means the more demand for goods and services so the demographics should have a direct effect on the consumption spending of the people.