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In macroeconomics, consumption expenditure affects the economy through aggregate demand. Economists include it as an item in aggregate demand in addition to business investment, government spending, and net exports. Thus, when consumption expenditure increases, aggregate demand also increases. As a result, it stimulates the economy to produce more output, leading to economic growth. Moreover, it also lowers the unemployment rate as businesses need more labor to produce more output.
Our expenses create income for companies. In other words, the money we spend becomes the revenue for them. Therefore, they will increase production to earn more profit when they believe we will spend more money (increased consumption).
Companies will utilize existing capacity at a higher level to produce more output. However, if the existing capacity is insufficient, they invest by buying capital goods or establishing a new factory. In addition, they also recruited more workers to operate their production machines. Eventually, it creates more jobs and income in the economy.
What are the types of consumption expenditures?
Consumption expenditures are what we spend to meet our daily needs. For example, we buy food, clothes, cars, insurance services, vacations, and hotels. These represent consumption, which includes goods and services.
How much is spent on services usually? It varies among consumers. High-income consumers may spend more money on services than low-income consumers. They buy services such as banking, investment, vacations, hotels, restaurants, health care, and insurance. Such spending may not be a priority for low-income consumers.
Then, spending on goods may also vary between consumers. Those who are rich can spend more money on luxury and branded goods. Meanwhile, low-income consumers find it difficult to buy such items. Their money may only be sufficient to meet basic needs.
Economists distinguish goods into two categories: durable goods and non-durable goods. Examples of durable goods are cars, motorcycles, washing machines, and furniture. Meanwhile, examples of non-durable goods are gasoline, food, beverages, and clothing.
Durable and non-durable goods have different characteristics related to how sensitive we are to buying them when external factors such as income and interest rates change. For example, when we buy durable goods, we may be sensitive to interest rates because we rely on loans to buy them.
Durable goods are usually expensive, and income may be exhausted when buying them for cash. Therefore, we buy it on credit. For this reason, durable goods require more consideration when purchasing.
What factors affect consumption expenditure?
Disposable income is the key determinant of consumption expenditure. Economists use it to explain changes in consumption. Both have a positive relationship, where higher income increases consumption and vice versa.
Disposable income is income after tax. Economists divide their allocations into two categories:
- Consumption
- Savings
As already explained, we expect consumption to increase when disposable income increases. Conversely, when it goes down, consumption goes down. So how big is the increase? Economists introduce two terms to answer it:
MPC represents the extra disposable income allocated to consumption. Say it is equal to 0.20. That means we allocate $0.2 as consumption for every $1 increase in our disposable income. The remaining $0.8 is to be saved.
Apart from disposable income, other factors also influence consumption expenditure, including:
Consumer confidence. When consumers are optimistic about their jobs and income, we expect them to spend more.
Consumer wealth. An increase in wealth, for example, due to an increase in the price of assets owned, encourages consumers to spend more.
Income expectations. For example, if consumers see their income increasing in the future, they are confident in their ability to spend more now.
Inflation expectations. For example, if future prices fall, consumers delay purchases to get lower prices in the future.
Interest rate. Rising interest rates encourage consumers to reduce spending financed by loans, such as durable goods.
How does consumption spending affect the economy?
Consumption spending affects the economy in many ways. The first is the impact on the company’s sales. Second, if changes in consumption occur across consumers in the economy, it affects aggregate demand. Third, consumption affects several economic variables, such as economic growth, inflation, and unemployment.
Effect on business
Businesses exist to meet consumer needs and wants. By serving consumers, they generate revenue. After deducting the costs, they make a profit. Costs tend to fall when firms produce at a higher scale, for example, due to higher economies of scale. Thus, the more consumers spend, the more profit and money they make.
Most businesses pay attention to numbers and consumer spending patterns. Both influence business decisions such as capital goods investment, recruitment, and product diversification.
For example, when consumer spending falls, businesses make less profit. As a result, they must carry out operating efficiencies to maintain profitability, including firing employees and reducing salaries. They also delay capital investment.
Conversely, when consumer spending increases, they are optimistic about their profitability. So, they are confident in investing in capital goods and recruiting more workers.
Meanwhile, consumption spending patterns also affect the company’s competitive strategy. For example, when consumers change tastes, their needs also change. The company must adapt to the situation, for example, by launching a new product or improving an existing product by adding new attributes.
Effect on aggregate demand
Economists define aggregate demand as the total expenditure by economic actors. It includes household consumption, business investment, government spending, and net exports. The latter refers to spending by foreign economic actors on domestic products (exports) minus spending by domestic economic actors on foreign products (imports).
Mathematically, economists formulate aggregate demand as follows:
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
The mathematical formula above clearly shows how consumption expenditures affect aggregate demand. Both have a positive relationship: Higher consumption spending increases aggregate demand, while lower consumer spending reduces aggregate demand.
Effect on economic growth
Consumption spending is a key driver of economic growth. It contributes significantly to GDP in many countries. For example, it accounts for about 60% of the GDP in the United States.
GDP measures aggregate output, which is equivalent to aggregate demand, as economists explain in the circular flow model. That is, what is spent by economic actors will equal the output produced in the economy.
And changes in real GDP represent economic growth. When real GDP increases, the economy grows. Conversely, when it falls, economic growth declines.
So, we can say that consumption expenditures are the key driver of economic growth because of their significant contribution to GDP. When consumption is stronger, it creates more demand for goods and services.
The increase in demand makes companies optimistic about their business prospects. They then respond by increasing output to make more profit. Finally, an increase in consumption spending leads to an increase in output in the economy, indicating that the economy is growing.
The opposite effect applies when consumption falls. Weaker consumption dampens economic growth as businesses respond by cutting output.
Because economic growth is sensitive to consumer spending, policymakers often focus on demand-side policies. Thus, they try to encourage consumption expenditures to stimulate short-term economic growth when the economy is sluggish. For example, the government cuts taxes or increases spending through fiscal policy. Or, through monetary policy, the central bank cuts the policy rate to lower borrowing costs and increase credit availability in the economy.
Effect on inflation
A decline in consumption spending affects the inflation rate, representing the percentage change in the economy’s price of goods and services. In short, it is an aggregate measure of price changes.
According to the law of demand, an increase in demand pushes the market price up. On the other hand, a decline in demand causes prices to fall. If the increase or decrease occurs for all goods and services in the economy, that is inflation.
Thus, the decline in consumption expenditures will not only cause economic growth to slow down. But, it also keeps prices down. This situation may only cause disinflation where the inflation rate slows down from the previous period, for example, from 5% to 3%. Some items reported falling prices, but some were still rising. As a result, in aggregate, the inflation rate only slowed down.
However, if consumption expenditures drop significantly, it could lead to deflation, where the inflation rate is in negative territory, for example, from 3% to -1%. Therefore, most goods and services in the economy fell, resulting in a sharp drop in the inflation rate.
Furthermore, a sharp increase in consumption expenditures could also hurt the economy. As a result, inflation rates would soar, overheating the economy. This situation can lead to hyperinflation, where the purchasing power of money falls rapidly.
When demand increases strongly, it pushes prices up sharply. Inflation rate rises. If consumers expect prices to continue to rise, they will spend more now, pushing inflation higher. If this continues, it causes inflation to spike and the economy to operate beyond its productive capacity (real GDP exceeds potential GDP). For example, this situation could send inflation out of control through the wage-price spiral.
In this situation, the central bank usually intervenes by raising interest rates. This measure aims to moderate the inflation rate by weakening aggregate demand.
Effect on the unemployment rate
An increase in consumer spending will encourage businesses to increase output. At the outset, they may not have invested in capital goods. Instead, they may just maximize the existing production capacity. They may also not have recruited new workers. Instead, they increase overtime to increase output to meet demand.
However, if demand gets stronger and exceeds existing capacity, businesses start investing. For example, they buy capital goods or build a new factory. In addition, they recruit new workers to operate the machines and factories. As a result, the unemployment rate decreases.
The opposite effect holds when consumption expenditure falls. Businesses will cut production while taking efficiency measures. However, they may still invest in light equipment to support efficiency. Besides, they might just stop hiring.
But, if demand falls further, businesses cut production further. They also stopped investing and cut workers to reduce pressure on profitability. As a result, the unemployment rate increases.
