Several factors affect consumption expenditure. Disposable income comes first. Without it, there is no income to buy the product. Other factors include consumer confidence, wealth, income expectations, inflation, and interest rates.
Why is it necessary to understand the factors affecting consumer spending?
Understanding trends in these factors is important for predicting how strong consumer spending will be in the future. For example, companies observe them determine their product demand. Meanwhile, the government often looks for ways to stimulate consumption to encourage economic growth. Thus, the government can make more effective policies by observing the determinants.
In some countries, consumer spending is the key to driving economic growth. This is because it contributes significantly to aggregate expenditures, represented by GDP. For example, it accounts for about 54.42% of Indonesia’s nominal GDP in 2021. And the percentage has remained relatively unchanged from year to year. Meanwhile, in the United States, the percentage is higher, reaching around 60%.
This percentage underlines how strategic consumer spending is for the economy. Thus, encouraging economic growth requires policymakers to encourage an increase in consumption spending.
When consumption increases, businesses increase output because they see a strong demand outlook. If demand grows stronger, they increase investment and recruit more workers. Ultimately, it leads to economic prosperity as more income and jobs are created.
So, what factors affect consumption expenditure? Here are the details:
- Disposable income
- Consumer confidence
- Consumer wealth
- Income expectations
- Inflation expectations
- Interest rate
Disposable income is a key determinant for consumption expenditure. Without income, there is no money to buy goods and services.
Disposable income represents the money left over after the consumer pays taxes. In other words, it is after-tax income. Meanwhile, income can come from salaries, bonuses, overtime, commissions, and paid leave.
Then, if we subtract disposable income with minimal living expenses – such as food, medicine, rent or mortgage, utilities, insurance, transportation, etc. – we get discretionary income.
Consumers allocate their income for two purposes: consumption or saving. While consumption meets their current needs, saving meets future needs, for example, in old age.
In general, income is positively related to consumption expenditure. Higher-income leads to more spending on consumption. Vice versa, lower income encourages consumers to reduce spending.
Taxes represent the mandatory dues paid by consumers to the government. Therefore, consumers must consider it first before allocating money for spending.
Taxes are inversely related to income and, therefore, to consumption spending. When it’s higher, disposable income goes down. Thus, less money is available for consumption expenditure.
Conversely, when the government cuts tax rates, it gives consumers more disposable income. Consequently, they have more money to spend on goods and services.
Consumption spending is closely related to consumer confidence. It influences consumers’ tendency to make big purchases, especially for durable goods, for which they usually require more consideration and rely on loans for purchases.
Typically, consumer confidence is closely tied to their income and employment prospects. In addition, their expectations of the economy also play an important role in shaping their confidence.
For example, when consumers are optimistic about income and employment, they are more likely to buy more goods. Moreover, they dare to buy durable goods and take out loans to finance them.
Conversely, when consumers are pessimistic, they tend to spend less. Therefore, they will save even more until the situation improves.
Pessimism and consumer optimism are usually closely related to economic conditions. For example, during expansion, consumers tend to be optimistic about their incomes and jobs as the economy is prospering. On the other hand, during a recession, they tend to be pessimistic as income and job prospects deteriorate.
Consumer wealth represents the total assets consumers own after deducting the total liabilities. Sometimes, specifically, we refer to it as net worth.
Consumers store their wealth in two groups of assets: real assets and financial assets. Real assets include land, property, and precious metals. Meanwhile, financial assets include bank deposits, stocks, bonds, and mutual funds.
Consumers save their wealth for a financial cushion during difficult times or retirement. They set aside their money by postponing current consumption. They expect to have at least sufficient wealth to sustain future needs.
How do wealth and asset prices affect consumption expenditure?
When asset prices increase, consumers see their wealth rise. As a result, they become more optimistic and if they have exceeded their targeted wealth accumulation, say in one year, they can set aside less income to save.
In contrast, consumers spend more income on consumption. As a result, they buy the product they are interested in or have been delayed.
Long story short, when asset prices rise, consumers are more confident to shop, prompting higher spending. Conversely, a decline in asset prices makes consumers spend less. Economists refer to the relationship between rising asset prices and consumer spending as the wealth effect.
When consumers are optimistic about their future income prospects, they tend to spend more. For example, they take out a new loan because they believe they can still make money in the future to pay the installments.
Conversely, when income prospects deteriorate, they will delay spending on some goods, especially durable goods. Income uncertainty causes them to consume less. Instead, they save more in preparation for a worse situation.
Future price expectations play an important role in influencing spending decisions. For example, you are interested in a product. And you expect the price to drop in the next month. As a result, you will delay the current purchase and will buy it in the next month. On the other hand, if the price is likely to go up, you should buy it now before it goes up next month.
And in general, price expectations are represented by inflation expectations. Inflation represents an increase in prices for the products they buy. It doesn’t just represent one or two products but a basket of purchased products. In short, it is an aggregate measure of the price increase.
High inflation erodes consumer purchasing power. Money becomes worthless. With the same nominal money, consumers get fewer quantities.
Thus, if consumers expect higher inflation in the future, they will increase spending today. But conversely, they will delay buying if they expect inflation to fall (deflation).
The interest rate denotes the cost of borrowing money. Therefore, consumers will think twice about applying for a new loan when interest rates rise because the cost is more expensive.
Durable goods like cars are expensive to buy in cash. Their prices may be many times the consumer’s income. Because of this, consumers often buy them on loan.
Due to high-interest rates, borrowing costs become more expensive. Thus, consumers are more likely to delay purchases. Moreover, these items are relatively less essential and are not primary needs. Therefore, they think delaying purchases is better than paying high-interest rates, which can hurt their finances.
Conversely, consumer spending on these goods will tend to increase when interest rates fall. Consumers are willing to take out new loans because they are cheaper.
And in general, interest rates are positively related to credit availability. When interest rates are low, more credit is available. In this situation, liquidity in the economy is abundant, and the money supply increases. The opposite condition applies when interest rates are high.
What to read next
- Consumption Expenditure: Type, Determinants, Impact
- Consumer Spending Patterns: Influencing Factors
- Which Factors Affect Consumption Expenditure?
- How Consumption Expenditure Affects the Economy