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Expenditures made by the household sector on final goods and services, or gross domestic product. Consumption expenditures play a central role in macroeconomic activity affecting both short-run business cycles and long-run economic growth. The motivation behind consumption expenditures is the general process of consumption, which is the use of goods and services to satisfy wants and needs, and are officially measured by personal consumption expenditures. These are one of four expenditures on gross domestic product. The other three are investment expenditures, government purchases, and net exports. Consumption expenditures average about 90 percent of household disposable income and account for about two-thirds of annual gross domestic product. These expenditures, which in general purchase the goods and services that satisfy wants and needs, are one of two basic uses of disposable income. The other is saving. Saving is diverted to the financial markets to fund investment expenditures and government purchases.
Consumption Times ThreeThe primary purpose of consumption expenditures is to obtain the goods and services that satisfy wants and needs. However, in some cases consumption occurs without expenditures and in other cases consumption expenditures do not provide satisfaction. Consumption and consumption expenditures are two of three related notions of consumption. The third is the official government measure of consumption--personal consumption expenditures.
- Consumption: This is the generic term for the use of goods and services to satisfy wants and needs. This activity may or may not involve actual purchases or expenditures. Consumption is the fundamental process in the economy that addresses the scarcity problem. In is, in effect, the ultimate goal of economic activity.
- Consumption Expenditures: This is the more specific term referring to actual expenditures on final goods and services, or gross domestic product, by the household sector.
- Personal Consumption Expenditures: This is the official measure of the consumption expenditures component of aggregate expenditures used in the calculation of gross domestic product. While the official number-crunchers try to measure ALL consumption expenditures, some are missed by the official calculation.
Saving: The Other SideThe household sector uses after-tax disposable income for one of two purposes. Consumption is one. Saving is the other. In particular, saving is the after-tax income that the household sector does not use for consumption expenditures.
This notion of saving is simple, but suggests greater complexity. Strictly speaking saving is any disposable income that the household sector does not spend. This unspent income could be stuffed in a mattress, buried in a coffee can, or tucked away in a dresser drawer. However, this unspent income is most often diverted to bank savings accounts and other financial markets.
Saving is important to the macroeconomy for two reasons.
- One, because saving is income that is not used to purchase output, greater saving means fewer expenditures. To maintain a balance between production and expenditures, saving must be matched by other expenditures.
- Two, saving does not disappear from the economy, but is diverted into the financial markets. These diverted funds are then borrowed by the other sectors, especially the business sector. The business sector uses saving to finance capital investment.
Business CyclesConsumption expenditures take center stage in the short run macroeconomic analysis of business cycles. Business cycles are the ups and downs of economic activity. The economy expands for several years, then it contracts for a year or two, then it expands again.
The total amount of expenditures undertaken by the household sector on gross domestic product can have a profound impact on the business-cycle activity. Should the household sector, in total, decide to spend more or less on goods used for consumption, then the macroeconomy can experience business-cycle expansions and contractions.
Suppose, for example, that the entire population of the country--the household sector--becomes increasingly optimistic about the state of the economy. They expect the economic future to be bright, rosy, and prosperous. As such, they increase consumption spending on new cars, new houses, and vacations. The result of this additional spending is short-run business-cycle expansion.
However, should the household sector, in mass, become increasingly pessimistic about the future of the economy, then they are inclined to decrease consumption expenditures. This reduction is likely to trigger a short-run business-cycle contraction.
Although sudden changes in consumption expenditures can cause business-cycle instability, at the very least, they cumulatively reinforce instability prompted by other expenditures. This occurs because consumption is induced by income. These other expenditures cause changes in household income, which then induce changes in consumption expenditures. If the household sector has more income, it increases consumption expenditures. If it has less income, it reduces consumption expenditures.
As such, if other expenditures, such as investment expenditures, increase or decrease, then consumption expenditures follow suit, amplifying or magnifying the overall impact on the economy. This is termed the multiplier process.
Economic GrowthConsumption expenditures also have a profound impact on the long-run growth of the economy. Devoting a larger (or smaller) share of household income to consumption expenditures means less (or more) is directed to saving. Saving is the primary source for funding investment expenditures on capital goods.
Capital goods are key to the productive capabilities of the economy. An increase in the quantity of capital expands the ability to produce goods and thus results in economic growth. A decrease in the quantity of capital diminishes this production capacity.
The tradeoff between consumption and investment is fundamental to the process of long-run economic growth. By devoting more resources to investment and less to consumption in the present, an economy generates greater economic growth in the future. By devoting more resources to consumption and less to investment, economic growth is less or even negative.
A Variety of ExpendituresConsumption expenditures are used to purchase a wide variety of goods and services--literally hundreds of thousands. However, in the macroeconomic analysis of consumption, these expenditures are commonly divided into three categories:
- Durable Goods: These are tangible goods that tend to last for more than a year. Common examples are cars, furniture, and appliances. Durable goods constitute about 10-15 percent of consumption expenditures.
- Nondurable Goods: These are tangible goods that tend to last for less than a year. Common examples are clothing, food, and gasoline. Nondurable goods constitute about 25-30 percent of consumption expenditures.
- Services: These are intangible activities that provide direct satisfaction to consumers at the time of purchase. Common examples include health care, entertainment, and education. Services constitute about 55-60 percent of consumption expenditures.
The Circular Flow
Consumption expenditures are a key component of the circular flow model of the economy. The circular flow captures the continuous movement of production, consumption, income, and factor services that move between producers and consumers.
|The Circular Flow
A basic representation of the circular flow is displayed to the right. The components of this model are the four macroeconomic sectors--household, business, government and foreign--and the three macroeconomic markets--product, resource, and financial.
The household sector at the far left of the circular flow contains the consuming population of the economy. The business sector at the far right of the circular flow includes all of the producers. The government sector is positioned in the middle of the diagram and the foreign sector is at the very top.
The product markets near the top of the flow direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction. The resource markets at the bottom of the flow direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction. The financial markets located just above the resource markets divert saving from the household sector to business and government borrowing.
The circular flow indicates that the income used by the household sector to purchase goods through the product markets is obtained by selling factor services through the resource markets. It also indicates that the revenue used by the business sector to pay for factor services obtained through the resource markets is generated by selling goods through the product markets.
Consumption expenditures are the flow between the household sector and the product markets. In particular, the household sector makes consumption expenditures to purchase a portion of gross domestic product from the business sector through the product markets. The household sector then pays for these purchases with income received from selling factor services to the business sector through the resource markets.
The continuous connection between consumption, gross domestic product, business revenue, factor payments, and income, is the essence of the circular flow.
DeterminantsAt the macroeconomic level, consumption expenditures tend to be steady and reliable. The household sector regularly devotes about 90 percent of its disposable income to consumption expenditures and regularly purchases about 65 percent of gross domestic product.
However, consumption expenditures do change from time to time. The causes of these changes are termed consumption determinants. Here are a few of the more important ones:
- Interest Rates: Because interest rates affect the cost of borrowing and because many durable goods used for consumption are purchased with borrowed funds, higher interest rates reduce consumption expenditures, and lower interest do the reverse.
- Consumer Confidence: If the household sector, as a whole, feels optimistic about the economy, then they are prone to undertake consumption expenditures, especially for durable goods, such as cars, houses, furniture, and kitchen appliances. Consumer confidence tends to be high and rising when the economy has been prosperous and expanding. Consumers, however, can be a fickle group. A hint of bad times, particularly signs of a contraction on the horizon, can cause consumer confidence to fall, which then causes a dip in consumption expenditures.
- Physical Wealth: This is the material, tangible possessions of the household sector, especially durable goods like cars, furniture, and small kitchen appliances. An increase in physical wealth generally reduces consumption expenditures. If consumers have recently purchased a number of durable goods, then they have less need to buy more, with a subsequent decrease in consumption expenditures.
- Financial Wealth: This is the money, stocks, bonds, mutual funds, bank accounts, and other documents that provide a claim to goods, resources, and productive assets. When consumers acquire more financial wealth, they tend to spend more freely, with a subsequent increase in consumption expenditures.
- Inflationary Expectations: Expectations of future prices and inflation work much the same for consumption expenditures as buyers' expectations work for market demand. Households seek to buy at the lowest price possible. If they suspect that prices will rise (that is, they expect rising inflation), then they are inclined to buy more today. As such, consumption expenditures increase.
Three More ExpendituresConsumption expenditures are one of four expenditures on gross domestic product made by the four macroeconomic sectors--household, business, government, and foreign. The other three are investment expenditures (business sector), government purchases (government sector), and net exports (foreign sector). All together these four are termed aggregate expenditures.
The total expenditures by the four sectors are typically summarized in the aggregate expenditures (AE) equation as the sum of consumption expenditures (C), investment expenditures (I), government purchases (G), and net exports (X - M).
- Investment Expenditures: Investment expenditures are the expenditures by the business sector on final goods and services, in particular, capital goods like factories and equipment, undertaken in a given time period. The official measure of investment expenditures is termed gross private domestic investment and is divided into three categories--nonresidential fixed investment, residential fixed investment, and changes in business inventories. Investment expenditures are the most volatile of the four expenditures. They are about 10 to 15 percent of aggregate expenditures. Macroeconomics looks to investment as the primary source of business cycles.
- Government Purchases: Government purchases are the expenditures by the government sector on final goods and services undertaken in a given time period. The official measure of government purchases is termed government consumption expenditures and gross investment, which reflects the fact the some government purchases are for consumption goods and some for capital investment. They are also about 10 to 15 percent of aggregate expenditures. Government purchases are a key tool of fiscal policy for used to address business-cycle instability.
- Net Exports: Net exports are the difference between exports (goods and services produced by the domestic economy and purchased by the foreign sector) and imports (goods and services produced by the foreign sector and purchased by the domestic economy). The official measure of net exports is simply termed net exports of goods and services. The two components of net exports are exports from the domestic economy to the foreign sector and imports from the foreign sector to the domestic economy. They are typically less than 5 percent of aggregate expenditures. Net exports play a relatively small role in the macroeconomy.
AE = C + I + G + (X-M)
CONSUMPTION EXPENDITURES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 21, 2024].
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