Knowing the determinants of consumption expenditure is essential. Governments often look for ways to stimulate consumption to encourage economic growth.
Consumer spending is a significant driving force in the economies of several countries. Consumption contributes to 64% -66% of Indonesia’s gross domestic product (GDP). Thus, increasing consumption means moving the economy.
Then, how to stimulate it? Of course, the government must know the factors that influence consumption. That way, the government can take appropriate policies.
Disposable income is the most important determinant of consumption expenditure. Without income, there is no money to buy goods and services.
Disposable income is the money left after consumers pay taxes. In other words, it is income after tax. Consumers can use it for consumption or saving.
Household wealth can be real assets such as land and property or financial assets such as shares and mutual funds. Usually, they save wealth for a financial cushion in difficult times or for retirement. They target how much wealth they must accumulate for each period, say a year.
Appreciation of asset prices raises household wealth and exceeds the target for the year. Because it has surpassed the goal, households will tend to save less.
Instead, they will spend more money on the consumption of goods and services. They buy several products they most interest in.
The effect of asset appreciation (increase in wealth) on household consumption is what we call the wealth effect.
Future income expectations
When consumers are optimistic about their income and employment prospects, they will tend to shop. They sure can still make money.
Conversely, when the prospect of income worsens, they will delay the expenditure of some goods. They will save more in preparation for a worse situation.
High inflation erodes consumer purchasing power. Money becomes worthless. With the same nominal cash and goods, they get a smaller quantity.
Inflation expectations play an essential role in influencing spending patterns. If households expect higher inflation in the future, they will increase spending now. They buy some durable goods before the price rises.
Interest rates and credit availability
For households, interest is the cost of borrowing money. The higher the interest rate, the more expensive it will be. Hence, they will think twice about applying for new loans when interest rates rise.
So why are interest rates necessary for consumption expenditure?
Some goods, such as cars and homes, are expensive and several times the income of consumers. So, they will buy it on credit, unless they have enough savings. They then applied for a new loan from the bank.
When interest rates are high, they will most likely delay a purchase. These items are less essential. Postpone the shopping is better than having to bear high-interest payments.
Interest rates and the availability of credit are closely related. When interest rates are low, credit availability is usually abundant. This often happens during a prosperous economy.