Consumer expenditure

Household consumption (C) - also referred to as consumer expenditure (CE) - is the single largest component of aggregate demand and typically comprises up to 60% of the value of total demand. [1]

Consumer expenditure is also the most stable component of aggregate demand. Consumer expenditure can be broken down into several categories, which typically include:

Categories

Food and non-alcoholic drinks
Alcoholic drink, tobacco & narcotics
Clothing & footwear
Housing, fuel & power
Household goods
Household services
Transport
Communication
Health
Education
Recreation and culture
Miscellaneous

Determinants of consumption

The role of income

While the connection between income and consumption was widely studied by political philosophers and economists, the first formal analysis of the connection is attributed to English economist, John Maynard Keynes, who, in The General Theory of Employment, Interest and Money, 1936, proposed a stable relationship between consumer spending and disposable income.

The consumption function

The Keynesian consumption function is expressed as:

Consumption
= a + bY

Where 'a' is autonomous consumption which is independent of disposable income, b is the marginal propensity to consume, and Y is the current level of 'absolute' income. The marginal propensity to consume is the additional spending resulting from additional income.

Autonomous consumption

Autonomous consumption is, effectively, that level of consumption which is not determined by income and would include consumption that could be funded by borrowing, or by running down savings (dis-savings).

Hence if income = 0, the level of consumption existing is autonomous consumption. In this simple model there is assumed to be no government, no taxation and no government transfers, so that income Y is equal to personal disposable income [2]

Induced consumption

The 'bY' element can be referred to as 'induced' consumption. In other words, the amount of consumer expenditure that is dependent on 'absolute' income during the current period. The reason why 'absolute' is significant is that later theories of consumption refer to 'relative' income over time. The 'b' component is the proportion of new income that goes towards spending and is formally known as the marginal propensity to consume (or mpc). This can be expressed as:

The marginal propensity to consume

=
Δ consumption
Δ income

Example

Year National income Consumption
2018 1200bn 700bn
2019 1300bn 760bn
2020 1400bn 820bn

The marginal propensity to consumer for 2020 is:

60bn
100bn
= 0.6

If we know that the autonomous level of consumption is, say 200bn, the complete consumption function would be:

Consumption
= 200bn + 0.6Y

This can be graphed to show the Keynesian consumption function:

The Keynesian consumption function

Mathematically, the intercept of the consumption function is autonomous consumption, a. Graphically, the gradient of the consumption function is the marginal propensity to consume.

Real world data clearly indicates that the relationship between consumption and disposable income is not linear, giving a clear indication that other factors need to be considered.

Other views of income

Following analysis of real-world evidence regarding the relationship between income and consumer spending, several alternative 'theories' were developed during the 1950s, including:

The Relative Income hypothesis

The Relative Income Hypothesis, developed by American economist, James Duesenberry, proposes that consumer spending is partly determined by what other individuals are spending. In other words, individuals consider what people in a similar financial position typically spend. If an individual receives more income they may adjust their spending to mirror the spending of others in the income category they have now joined.

This may seem more a sociologically based theory than one from mainstream economics, but with the increase in interest in behavioural economics, many feel that Duesenberry highlighted the importance of the 'social context' in influencing economic behaviour.

The Life-Cycle Hypothesis

According to the Life Cycle Hypothesis, developed by Italian-American economist, Franco Modigliani, individuals current spending is adjusted to take into account that individuals may prefer to have a smooth level of spending throughout their life time, which means they may choose to save more while they are working so that they have income available for retirement.

Permanent Income Hypothesis

American economist, Milton Friedman, also proposed that consumption was not simply determined by current, absolute, income. According to Friedman, spending is based more on average, or permanent, income over an extended period of time, which is not greatly influenced by temporary or transitional income. 'Permanent' income is derived from past income, current income and expected future income.

In this hypothesis, individuals may have to accept fluctuating income but do not like fluctuating consumption which is 'anchored' to the individual's assessment of their permanent income. [3]

If individuals believe that a recent increase in income will not be sustained into the future, they will not adjust their current expenditure. For example, an individual that receives an unexpected bonus may save much more of this than is normally saved.

In conclusion, there are alternatives to the basic view that consumer spending is determined by current income, but whichever alternative theory is chosen, it is clear that income is the primary determinant of consumption.

Other determinants of consumer spending

Consumer expenditure may be influenced by a whole range of factors, some of which affect disposable income while others work more directly on consumer spending.

  1. Wealth levels – increases in levels of wealth, such as increases in the value of property assets and share values are likely to increase household consumption through 'equity withdrawal'. This means that individuals may obtain finance which is backed by property or other assets.

  2. Savings – decisions to save clearly affect decisions to spend – more saving means less is available for spending. An autonomous decision to increase savings - say, to save for retirement - will impact on decisions to spend. Hence it is important to understand the factors that can affect savings decisions, such as confidence, savings rates, and job security.

  3. Taxation – direct taxes, such as income tax, and other charges, reduce disposable income. Changes in tax rates or tax levels will directly affect what is available for households to spend.

  4. Debt levels – increases in consumer debt are likely to lead to reductions in consumption as individual switch from consumption to funding existing debt.

  5. Interest rates – changes in interest rates affect how much income is spent, and whether it is saved. A rise in interest rates will means that credit card and mortgage repayments will increase, leaving less available for spending on other goods and services.

  6. Unemployment – increases in unemployment, such as those resulting from the Covid-19 pandemic, or from the financial crisis or other recessions, will reduce consumption across an economy.

  7. Inflation – price inflation erodes the purchasing power of a given amount of income, and, in general is likely to reduce consumer spending. However, if the inflation rate is relatively high and sustained it can encourage people to bring forward their spending plans in the hope of avoiding the effects of future inflation. It is for this reason that the inflation rate may accelerate as individuals look to bring forward their decisions to purchase. However, the effect if likely to be weak when inflation is between 1 and 2%.

  8. Confidence – changes in consumer confidence may alter the patterns and levels of spending. Confidence levels can be assessed through surveys, and the creation of a consumer confidence index, such as the Consumer Confidence Index (CCI) created by the US Conference Board. The OECD produces a general consumer confidence index from data from its members:

  9. Government and financial policy – government or central bank intervention can have a direct bearing on consumer spending, either through its effect on disposable income, or through interest rate changes.


Structural unemployment

What is structural unemployment?

Structural unemployment
Taxation

How can taxes regulate consumption?

Taxation
Supply-side policy

How effective is supply-side policy?

Supply-side policy

[1] House of Commons Library viewed June 10 2021, https://commonslibrary.parliament.uk/research-briefings/sn02787/

[2] Personal disposable income is income to households from firms, plus transfers such as state benefits, less taxes paid to the government.

[3] Begg D, Vernasca G, Fischer S, Dornbusch R, 2014 Economics, 11th Edition, , McGraw Hill