Consumption Expenditure

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Services are intangible things consumers buy, like healthcare or entertainment.

The three main factors that affect consumption are:

• Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
• Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
• Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. rates of saving declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so rates of saving increased while consumption declined.

A variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will shift out to the right.

The Keynesian Aggregate Expenditure Model
Consumption is the largest component of the GDP and therefore the patterns and changes in consumption have the potential to shape the macro economy. Spending Patterns The Consumption function (see Example 1 data and graph below) illustrates some of the patterns of Consumption: as Aggregate Income (Comparable to GDP) increases in the economy, Consumption also increases; in other words, the higher the income, the greater the consumption. Aggregate Income = Consumption + Saving .  There are only 2 options for your income, spend it or save it. While Consumption accounts for the largest share of our income, saving does increase with higher income. There is a minimum level of consumption for an economy that is independent from the income level which is labeled Autonomous consumption and is graphically represented in the Y intercept of the Consumption function ($1000 million in Example 1 below) At lower income levels, dissaving (negative saving) can occur when Consumption is higher than income while at higher income levels, saving becomes positive. The critical income level where Consumption  equals income and saving is zero can easily be spotted on the graph where the Consumption function intersect the 45 degree line.  The 45 degree line often present on the graphical representation of the Consumption function is used to facilitate the identification of this critical aggregate income level.	Source: BEA.gov Example 1 – Consumption Patterns – Table and graph
To measure these patterns, economists use the Average Propensity to Consume to represent the proportion of Aggregate Income that is spent and Average Propensity to Save to show the proportion of Aggregate Income that is saved. Average Propensity to Consume – APC = Consumption / Agg. Income For instance, in the example above, at the income level of $5000, the APC = $4750 / $5000 = 0.95 or 95% Average Propensity to Save – APS = Saving / Agg. Income For instance, in the example above, at the income level of $5000, the APS = $250 / $5000 = 0.05 or 5% You can notice that since Aggregate Income = Consumption + Saving, then APC + APS = 1	Another critical measurement is the Marginal Propensity to Consume that measures how Consumption changes along with Income in other words, if the economy increases aggregateincome by $1000 million, Consumption will increase by $750.  Similarly, the Marginal Propensity to Save measures the change in Saving due to a change in Income. Marginal Propensity to Consume – MPC = Change in Consumption / Change in Agg. Income For instance, in the example above, when the income level rises by  $1000, the MPC = $750m / $1000 = 0.75 or 75% Marginal Propensity to Save – MPS = Change in Saving / Change in Agg. Income For instance, in the example above, when the income level changes by $1000, the APS = $250m / $1000 = 0.25 or 25% You can notice that since Aggregate Income = Consumption + Saving, then MPC + MPS = 1

Investment Expenditure

Spending on new capital goods is called investment expenditure. Investment falls into four categories: producer’s durable equipment and software, new nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings). The first three types of investment are conducted by businesses, while the last is conducted by households.

Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected benefits of the investment (expectations of future profits) and the costs of the investment (interest rates).

• Expectations of future profits: The clearest driver of the benefits of an investment is expectations for future profits. When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.
• Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.

Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.

Government Spending

The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, government still plays a significant role in the economy and provides important public services such as national defense, transportation infrastructure, and education.

Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could AD be stimulated by more government spending (or reduced by less government spending), but consumption and investment spending could be influenced by lowering or raising tax rates. Indeed, Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.

Net Exports

Recall that exports are products produced domestically and sold abroad while imports are products produced abroad but purchased domestically. Since aggregate demand is defined as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.

Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. The level of demand for a nation’s exports tends to be most heavily affected by what is happening in the economies of the countries that would be purchasing those exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the quantity of a nation’s imports is directly affected by the amount of income in the domestic economy: more income will bring a higher level of imports.

Exports and imports can also be affected by relative prices of goods in domestic and international markets. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.

Table summarizes the reasons given here for changes in aggregate demand.

How Changes by Consumers and Firms Can Affect AD

When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.

The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported at http://www.sca.isr.umich.edu, which break down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which is considered close to being considered a healthy state.

One measure of business confidence is published by the OECD: the “business tendency surveys”. Business opinion survey data are collected for 21 countries on future selling prices and employment, among other elements of the business climate. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages (the indicator dips below zero when business outlook is weaker than usual). Of course, either of these survey measures is not very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.

Because a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E₀ to E₁, to a higher quantity of output and a higher price level, as shown in Fig.1 (a).

Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. A shift of AD to the left, and the corresponding movement of the equilibrium, from E₀ to E₁, to a lower quantity of output and a lower price level, is shown in Fig. 1 (b).

How Government Macroeconomic Policy Choices Can Shift AD

Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, while lower government spending will cause AD to shift to the left. For example, in the United States, government spending declined by 3.2% of GDP during the 1990s, from 21% of GDP in 1991, and to 17.8% of GDP in 1998. However, from 2005 to 2009, the peak of the Great Recession, government spending increased from 19% of GDP to 21.4% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP was about $14.4 trillion in 2009, a seemingly small change of 2% of GDP is equal to close to $300 billion.

Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.