Consumer Confidence: Its Effect on Aggregate Demand and the Economy

What’s it: Consumer confidence describes how optimistic and pessimistic consumers are about their daily lives. It is usually associated with their economic and financial condition. When consumers are optimistic about their economic and financial condition, we expect them to increase consumption.

An increase in consumption pushes aggregate demand up and shifts its curve to the right. As a result, real GDP grows, and the economy produces more output. Businesses see demand for their products increase, prompting them to increase production. They started investing in capital goods and recruiting new workers. As a result, aggregate demand rises, and the unemployment rate falls.

Why is consumer confidence important?

Consumers’ optimism and pessimism affect their decisions in spending money. We expect them to spend more money on goods and services when optimistic. Conversely, when they are pessimistic, they spend less and save more.

And such confidence has a major impact on aggregate demand and the economy because household consumption contributes dominantly to gross domestic product (GDP). In general, household consumption accounts for about 60% of GDP. For example, in the United States, the percentage was 68.5% in 2011. In the United Kingdom, it accounted for 61.5% in 2020. Whereas, in Indonesia, it contributed about 55.6% in 2020.

High consumer confidence stimulates the economy to grow through its effect on spending. Finally, it contributes to a decrease in the unemployment rate, an increase in business profitability, and an increase in household income. This situation leads to a prosperous economy.

Where does consumer confidence come from?

Consumer confidence comes from optimism and pessimism about their current and future economic and financial conditions. They consider factors such as their job and income. For example, they are optimistic when their income increases, more jobs become available and future prospects on both improve. Conversely, if their income and job prospects deteriorate, their pessimism increases.

Economic conditions and business conditions also play a role in influencing consumer confidence. Take the inflation rate as an example. If the inflation rate is high and is expected to continue to rise, they are optimistic about shopping now. This is because they avoid having to pay a higher price later on. But, on the other hand, if they see it going down, they will postpone shopping now to get cheaper prices in the future.

How does consumer confidence affect aggregate demand and the economy?

Consumer confidence influences consumer decisions to spend money. When they are optimistic, they will tend to spend more money on shopping. Conversely, when their confidence is low, they will tend to save more and consume less to anticipate worsened conditions in the future.

High consumer confidence

Consumer confidence increases as the economy grows. They see economic and business conditions improving. Thus, they feel optimistic about their income and job stability.

Optimistic consumers tend to spend more money on shopping. For this reason, the demand for goods and services increases. It then increases aggregate demand and shifts its curve to the right.

In this situation, businesses are also more confident in their performance. The increase in demand makes their profitability prospects increase. They then try to increase production to reap more profit. And they will operate at or near full capacity to maximize production at their existing facilities.

Then, if demand is still strong, businesses start ordering capital goods to increase output. They also recruit new workers. In addition, high demand also gives them the opportunity to increase selling prices.

As a result, consumer optimism, in turn, helps the economy sustain expansion. Eventually, it leads to a decrease in the unemployment rate and an increase in income in the economy. Nonetheless, it also results in higher inflationary pressures.

Low consumer confidence

When confidence is low, consumers tend to delay purchases. Their consumption goes down. Instead, they will save more.

Usually, items such as durable goods were the most affected. Because they are more expensive, consumers have to spend more money to buy them. Therefore, when consumers are pessimistic, they will first cut spending on durable goods.

Pessimism usually arises during a difficult economy, such as a contraction. First, the economy is facing negative growth. And real GDP fell. The labor market faces fewer available jobs as businesses take efficiency measures to maintain profitability. As a result, job prospects and household incomes deteriorate. Finally, their financial condition is depressed, increasing their pessimism.

This pessimism could make the economy worse off. In other words, an economic contraction could lead to a recession. Suppose consumers are still not confident about their future economic and financial condition. In that case, they will cut spending further and save more. Hence, the demand falls more deeply. It then decreases aggregate demand and shifts its curve to the left.

The deeper fall in demand made the business profitability outlook worse. As a result, their business and financial performance are getting depressed. They then take more stringent efficiency measures. For example, they may simply cut hours and freeze hiring at the start of a recession. But, when the situation worsened, they laid off their employees. They may also cut prices to avoid cost overruns from stockpiling goods in warehouses.

The unemployment rate is rising, and the outlook for household income is falling. As a result, households are increasingly pessimistic about their future condition. Eventually, the contractions can get worse, leading to a recession or even depression.

This situation also leads to deflation, where the inflation rate is in negative territory. As a result, prices fell, prompting consumers to postpone current consumption.

How is consumer confidence tracked?

The consumer confidence index is widely seen to know the economy in the future. It’s one of the popular economic indicators.

The index measures consumers’ optimism about their current and future economic and financial health. However, how it is measured varies between countries concerning the method and the variables being tracked.

Consumer confidence index components

The index is generated from the two constituent indices, namely:

Current economic conditions index
Consumer expectations index

The current economic condition index describes consumer confidence in current conditions compared to the past. The variables tracked included income and job availability. It also tracks consumer purchases, particularly related to the timeliness of purchasing plans for durable goods such as cars, homes, and major appliances, for which spending on them involves more money and consideration.

Present Situation Index and Expectation Index, Taken from The Conference Board — Taken from The Conference Board

Meanwhile, the consumer expectation index tracks consumer confidence in their future condition, for example, in the next 6 months. Variables include income expectations, business conditions, economic conditions, and job availability.

Then, the consumer confidence index is calculated by taking the simple average of the two indices. This practice may differ between countries. For example, Indonesia uses the simple average. In other words, the current economic conditions index and the consumer expectations index have equal weight in the consumer confidence index. But, in other countries, it may use different weights, say 60% for the expectations index and 40% for the current condition index.

How to read the consumer confidence index

In Indonesia, an index above 100 indicates a more optimistic response than a pessimistic response. On the other hand, an index below 100 indicates a more pessimistic response than an optimistic response. Meanwhile, The Conference Board’s index uses 1985 as the base year with the number 100. So, if the number is higher than 100, consumers are more confident than in 1985. The opposite reading applies if it is below 100.

The Conference Board'a Consumer Confidence Index — Taken from The Conference Board

So, in general, higher numbers indicate higher consumer optimism. Moreover, it usually takes place during an economic expansion. On the other hand, the index tends to be pessimistic during a difficult economy such as a recession.

Consumer Confidence: Its Effect on Aggregate Demand and the Economy

Why is consumer confidence important?

Where does consumer confidence come from?