Blog
AS Macro Revision: The Importance of Consumption
30th May 2010
Consumer spending on goods and services is the main driver of aggregate demand in the British economy. Over sixty five per cent of demand comes from the household sector and the strength or weakness of household spending has a major bearing on movements in the economic cycle.
In 2009 the real level of consumption dropped by 3% - one of the steepest declines in consumption for many years. It helps to explain the severity of the recession. Consumer spending is forecast to recover in 2010 but growth will be relatively weak and this has contributed to fears of a double-dip recession
Changes in consumer spending have a big impact on other aspects of the economy:
1/ They affect the level of spare capacity in markets and the level of planned investment by businesses
2/ Changes in consumption affect the flow of direct and indirect tax revenues flowing into the government
3/ By impacting on aggregate demand, changes in consumption affect the level of demand-pull inflationary pressure
4/ UK consumers have a high marginal propensity to import - changes in consumption have a direct bearing on the balance of trade in goods and services
5/ Swings in consumer spending and saving have a huge effect on the labour market. The fall in consumption in 2009 was a big reason why unemployment rose so steeply last year.
Revision on the key factors that drive consumer spending
Factors that affect consumer demand
* A change in interest rates – lower interest rates act to lower the cost of servicing the debt on a mortgage and thereby increase the effective disposable income of homeowners. One of the features of the current recession has been the sharp reduction in official ‘policy interest rates’ by central banks. Nominal interest rates in the UK have been cut to 0.5% and are likely to stay there for some time. But despite this consumption fell in 2009 - telling us that other factors were having a strong effect on planned spending
* A change in real disposable incomes - real disposable income is the money value of household income adjusted for the effects of price changes and after direct taxes and welfare benefits have been included. When disposable incomes are growing, people have more money in their pockets and bank accounts to increase spending on goods and services
*A change in household wealth – for example a sustained fall in house prices might cause a decline in personal wealth and spending as homeowners have less housing equity available to borrow. This is sometimes referred to as the negative wealth effect.
*A change in consumer confidence – for example, fears of rising unemployment and expectations of higher taxes (as the government seeks to cut the budget deficit) will hit consumer sentiment and spending
*A change in the supply of credit - One of the features of the credit crunch has been a slump in the flow of credit available for both households and businesses – banks became less willing to lend and the rate of interest charged on unsecureedd loans and overdrafts has increased. The supply of mortgage finance has contracted and would-be homebuyers now need to find a bigger deposit before getting a home loan. The loan to valuation ratios have fallen that has affected people’s ability to borrow to fund property purchases.
Geoff Riley
Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.