What’s is: Household consumption refers to the final household expenditure on goods and services. Items can be classified as durable goods, nondurable goods, and services.
Household consumption is a key indicator for analyzing demand in the economy. Consumption usually accounts for a large percentage of gross domestic product (GDP). In fact, in some countries, the percentage reaches more than 50%.
Also known as household final consumption expenditure or household expenditure.
Factors affecting household consumption
Income is the main determining factor for household consumption. Without income, households do not have money to buy goods and services.
Apart from income, other factors affecting household consumption are:
- Future income expectation
- Interest rate
- Income distribution
- Demographic factors
- Tastes and preferences
In macroeconomics, among several variables, disposable income is the primary determinant of consumption. Economists state household consumption as a function of disposable income.
We calculate disposable income by deducting the tax from household income. Income here includes those received from transfer payments.
Disposable income = Income – Tax
Thus, disposable income increases when:
- Pre-tax income increases
- Income tax is down
From disposable income, households have two main choices, save or consume. An additional 1 dollar of income allocated to consumption refers to the marginal propensity to consume (MPC). Meanwhile, the extra saved is referred to as the marginal propensity to save (MPS).
MPC plus MPS must be equal to 1. The concept of MPC is useful for explaining the multiplier effect of consumption on the economy. A high MCP increases the impact of consumption on the economy.
Multiplier = 1 / (1-MPC)
Household wealth consists of real assets and financial assets. When the prices of assets such as stocks and bonds rise, household wealth increases.
Higher wealth encourages households to spend more. When their assets increase, they feel they have hit their wealth-gathering target. Therefore, they will spend any additional income on the consumption of goods and services.
We call the relationship between asset prices and expenditure the “wealth effect.”
You need to remember. In this case, we assume that the liabilities (such as a mortgage loan) do not change.
Future income expectation
Household optimism affects their behavior in spending money. If households are optimistic that their future income will increase, current spending will increase. This condition generally occurs when economic growth is expanding.
The economic expansion brings more prosperous conditions. The unemployment rate is low, and the income outlook is improving.
Conversely, during a recession, the downward pressure on income and consumption increases. Households are becoming more pessimistic about their jobs and income. Shrinking economic activity indicates that businesses are likely to cut their labors, pushing the unemployment rate higher.
Interest rates affect household consumption and saving behavior. An increase in interest rates stimulates households to save more to obtain higher interest income. As households save more, the allocation for consumption is reduced.
Also, interest rates make borrowing costs more expensive. Households often rely on bank loans to purchase items such as cars and houses. Consequently, when interest rates rise, they will tend to delay such purchases.
Conversely, lower interest rates reduce borrowing costs. Households will usually apply for new loans to facilitate the purchase of durable goods.
Also, low-interest rates mean low-interest income. As a result, they are likely to save less.
Inflation and its expectations influence consumption decisions, primarily through their effect on real income and the real interest rate.
For example, when households expect higher inflation in the next month, they are more likely to buy durable goods now. That’s because current income has a greater purchasing power than in the future.
Conversely, if households expect deflation (falling prices) next month, they will postpone their current purchases. They will buy in the next month, hoping to get lower prices.
High-income households tend to have a smaller MPS than those with low incomes. Thus, income distribution programs (such as transfer payments) can encourage greater consumption of low-income households.
This includes age, education, and family size. They affect consumption patterns by households.
Tastes and preferences
These factors are difficult to measure and change over time. Economists don’t usually try to explain these variables. These factors depend more on psychological forces, which are outside the realm of economics.
Why is household consumption important
The study of consumption theory has helped economists formulate various concepts such as consumer surplus, decreasing marginal utility, and demand law. These theories help understand how individual behavior affects input and output in the economy.
Consumption plays a vital role in the theory of income and employment. Keynesian economists argue that if consuming goods and services does not increase the demand for those goods and services, it decreases production.
A decline in production means businesses will lay off workers, resulting in unemployment. A high unemployment rate means more people are losing income. That, in turn, reduces consumption further.
The effect of household consumption on the business cycle
Household consumption expenditure contributes around 55% of Indonesia’s Gross Domestic Product (GDP). The remaining third is government spending and net exports.
Consumption falls into three categories:
- Durable goods are tangible items with a useful life of more than three years
- Nondurable goods such as food and beverages, which are entirely consumed once.
- Services, which are the act of helping or doing work for another party.
Consumption spending can help understand fluctuations in the business cycle. During the economic recession phase, spending on durable goods decreases. They are expensive, and to buy them, households often borrow from banks. Therefore, during this period, they will postpone purchases until economic conditions improve.
As the economic recovery progresses, spending on durable goods increases. Because the price is relatively high, consumers will usually ponder carefully before buying.
When they see the economy will be better off in the future, they will buy it right away. Moreover, interest rates will usually remain low in this situation because the central bank is most likely to still keep interest rates low. The central bank will raise interest rates if the economy enters an expansion phase.
Hence, buying durable goods early in the economic recovery makes sense. Ultimately, the consumption of these durable goods will increase aggregate demand in the economy. That will stimulate business to increase output. And in the end, it will bring the economy into an expansionary phase.