Consumption expenditure represents spending by households. It covers purchasing three product categories: durable goods, nondurable goods, and services.
Consumption accounts for the majority of gross domestic product (GDP) in several countries. Consequently, the government often focuses on expenditure side policies to boost the economy.
Determinants of consumption expenditure
The primary determinant of consumption expenditure is disposable income. It is household income after paying taxes, i.e., income after taxes.
Economics divides disposable income allocation into two:
Likewise, when households get extra income, they will spend money on both. How many portions do they spend on each? That gave rise to two concepts in economics:
- Marginal propensity to consume (MPC), i.e., extra income consumed.
- Marginal propensity to save (MPS), part of the additional income saved (MPS = 1 – MPC).
Why consumption is essential for the economy
Business exists to meet the needs and wants of consumers. By serving consumers, they can make a profit. The higher the consumer’s expenditure, the more profit and money they make.
Thus, most businesses pay a lot of attention to the numbers and patterns of consumer spending. They follow consumer spending statistics when making sales estimates in the future.
For the economy, consumer spending is the most significant component of GDP. That accounts for around 60% of Indonesia’s GDP. In the United States, the United Kingdom, Japan, and other developed countries, it accounts for 70-80%.
As a result, GDP is sensitive to consumption trends. For this reason, it is not surprising that demand-side policies often more focused on driving consumer spending. The government and the central bank consider spending patterns when adopting fiscal and monetary policies.
Consumer spending is the key driver of short-term economic performance. When consumption is healthy, it creates demand and urges businesses to produce more. That ultimately creates more employment and income in the economy.
If consumer spending falls, businesses will drop. They must take operational efficiency measures to maintain profitability, including by firing employees and reducing salaries. As a result, it can lead to higher unemployment and weaker income prospects.