Question

Graphically illustrate and explain

- what happens to consumer spending when consumers become more optimistic about the future, i.e., consumer expectations rise

- how an increase in the interest rate would affect consumer spending

- what happens to consumer spending in response to an increase in consumer income

Answer 1

Consumer's spending or expenditure depends on many factors such as interest rate, the income of the consumer, price of the product, advertisement, price of substitute or complementary goods, gains from capital, habits, the expectation in future and attitude, etc. These are the factors which affect the consumer's expenditure directly but there are other factors also which are not noted and will affect the consumer's expenditure or demand for goods, such as demonstration effect, bandwagon effect, etc.

Consumer's spending mainly depends on the demand for goods. The demand curve change due to the consumer's preferences. The demand curve shifts when the consumers become more optimistic or its expectations rise. The demand curve either move along the curve or shifts. There are various other reasons for the shift but it is mainly due to consumer's preferences.

This can be explained with the help of diagram below:

The demand curve shifts towards the left when the consumer's expectation are high that is the prices will lower and if the consumers expect that the prices will rise in future then their demand increases and thus the demand curve shifts towards the right.

This is stated in a book by William A. McEachern called ' Economics: A Contemporary Introduction' that when the consumers expect the prices to be high then they demand more which increases the consumer's spendings and when they expect that the prices are going to fall then they wait and this time the consumer's spending decrease.

Consumer function states that consumer spending depends on the income of the consumer. The income is further divided into investment and saving. According to Keynes, aggregate consumption is a function of current disposable income. The psychological law of consumption given by Keynes states that the rate of increase in income is greater than the rate of increase in consumption.

One of the factors which affect the consumer's spending is the expectation of the consumer. When the consumer's expectations increase, consumer spending will decrease. This is so as the consumers are rational and they demand more when the prices are less as per the law of demand other things remaining constant.

Interest rate is the function of savings. When interest rate is higher then the people are attracted towards saving as they would gain more but if the interest rate is low then the consumers will prefer to invest rather than save as they will not gain enough interest out of it. This will result in changes in consumers spending. When the interest rate is high, consumers save and thus less consumer expenditure. On the other hand, when the interest rate is low, people do not save and therefore consumer spending will increase.

There is a direct relationship between income and consumers expenditure. As the income of the consumers increases the demand for the goods increases and thus there is an increase in the consumer's expenditure or spending as per the law of psychological law of consumption stated above. Therefore an increase in consumer income will increase the consumer's spending. This can be shown from the diagram below:

Therefore, these are the diagrams which explain the effect of income and rate of interest on consumer spendings or expenditures.