That creates inflation. The second component is income per capita. It tells you how much each person has to spend. Income measurements might rise just because the population increases. Income per person reveals whether each person's standard of living is also improving.
Income inequality is the third determinant of spending. Some people's income may rise at a faster pace than others. The economy benefits when most of the gain goes toward low-income families. They must spend a more significant share of each dollar on necessities until they reach a living wage. The economy doesn't benefit as much when increases go toward high-income earners. They are more likely to save or invest additions to income instead of spending.
The fourth factor is the level of household debt. That includes credit card debt, auto loans, and school loans. Current consumer debt statistics show that household debt has reached new record levels. Surprisingly, high health care costs are one of the biggest causes of overwhelming debt. The fifth determinant is consumer expectations. If people are confident, they are more likely to spend now. The Consumer Confidence Index measures how confident people are about the future.
It includes their expectations of inflation. If consumers expect inflation to be high, they will buy more now to avoid future price increases. Consumer spending is the single most important driving force of the U.
Keynesian economic theory says that the government should stimulate spending to end a recession. On the other hand, supply-side economists believe the government should cut business taxes to create jobs. But companies won't boost production without demand no matter how low taxes are. If you doubt this, think about what would happen if everyone stopped spending. Businesses would eventually go bankrupt and lay off workers.
The government would then have no one to tax. The economy would have to rely on exports, assuming other countries kept up their consumer spending. Borrowing would keep the government and factories open. These additional components of the gross domestic product aren't as critical as consumer spending. Even a small downturn in consumer spending damages the economy.
As it drops off, economic growth slows. Prices drop, creating deflation. If slow consumer spending continues, the economy contracts. But too much of a good thing can also be damaging. When consumer demand exceeds manufacturers' ability to provide the goods and services, prices increase. If this goes on, it creates inflation. Households may perceive financial wealth fluctuations as being less persistent with the result that they do not necessarily have an impact on short-run dynamics in consumption.
Source: Author calculations — see de Bondt, Gieseck and Zekaite. Notes: Ranges and averages are based on selected equations from a thick modelling approach assuming long-run unit elasticity of income and wealth: 43 for the first income decomposition and 13 for the second. Labour income is defined in two different ways: i total compensation of employees minus direct taxes or total compensation of employees minus direct taxes and net social security contributions plus net social benefits and other current transfers; ii total compensation of employees plus mixed income i.
Property income is the sum of gross operating surplus excluding mixed income, net interest income, net other property income and net other current transfers. Private consumption growth has closely followed growth in household income. This section sheds more light on the drivers of household income and their implications for overall spending on consumer goods.
This stands in stark contrast to the contribution of property and mixed income, or the income households receive from holding assets, which has remained almost unchanged since As the economic expansion progressed, the contribution of taxes and transfers became somewhat more negative in In good times automatic fiscal stabilisers tend to have a dampening effect on the growth of real disposable income. Note: All income components are deflated with the GDP deflator.
The contribution from the terms of trade is proxied by the differential between the GDP and consumption deflators.
Consumption and total disposable income are deflated with the consumption deflator. Despite broad-based increases, labour income in some countries remains significantly below its pre level.
With an increase in the number of employed persons of around eight million since , the current recovery in the euro area labour market has been remarkable. For example, in Italy and Spain real compensation of employees remains significantly lower than before the crisis see Chart 9 , on account of both crisis-induced wage moderation and unemployment remaining elevated.
Moreover, strong employment growth also reflects increased labour market participation among older as well as female workers. As the unemployment rate in some countries has not yet returned to pre-crisis levels, unemployment risk is still dampening consumption growth to some extent. Despite the strong consumption growth since , this is clearly an important reason why, in these countries, private consumption has not yet recovered to its pre-crisis level see Chart 5.
Note: Real labour income is measured as compensation of employees divided by the consumption deflator. Income risk remains elevated in the lower part of the income distribution. While the recovery in the labour market has boosted household income growth over the past few years, a significant share of the population continues to face a high degree of income risk.
Chart 10 shows how net household income for lower skilled workers has remained far below that for higher skilled workers see also Box 2. This is even more true for low-skilled workers in countries that were more affected by the financial crisis e.
Italy, Spain. Note: Equivalised disposable income is the total income of a household, after tax and other deductions, that is available for spending or saving, divided by the number of household members converted into equalised adults; household members are made equivalent by weighting each according to their age. Falling unemployment should continue to support aggregate consumption growth.
Households in the lower part of the income distribution i. As the recovery in the labour market also reaches these households, aggregate consumer spending should receive additional impetus and continue to contribute to a low aggregate saving ratio see Section 4. In addition, as the likelihood of becoming unemployed decreases also for low-skilled workers who are already employed, the available evidence suggests that they should also increase their consumption.
All in all, this suggests that as long as the recovery in the labour market remains on track the underlying growth momentum of private consumption can be expected to continue. Property income has remained weak since , but the impact on private consumption growth seems limited. Together with the fall in economic activity and corporate profitability, property income and mixed income from self-employment has fallen significantly since This is a normal phenomenon, as profits are strongly procyclical.
It is also in line with evidence that income risk across the business cycle is concentrated in the left and the right tails of the income distribution. This is because aggregate asset holdings are concentrated at the top of the wealth distribution see Chart In real mixed income gross operating surplus started to increase again, but most other components of property income have remained subdued see Chart Firms have not yet started to distribute more profits to their shareholders.
As richer households also tend to have a higher average saving ratio see Chart 11 , the dampening effect on private consumption may have been contained see also Box 1. Despite exceptionally low interest rates, household net interest income has hardly been affected. Between the third quarter of and the fourth quarter of interest payments fell by about three percentage points relative to disposable income.
Lower interest rates have mainly redistributed resources from net savers to net borrowers. As net borrowers typically have a higher propensity to consume than net savers, this redistribution channel of lower interest rates supports aggregate consumption. The net interest income of the household sector has remained fairly stable in Germany and France, but less so in Italy and Spain. Evidence from the sectoral accounts see Chart 13 shows that in Germany and France the drop in interest earnings and payments has been comparable, meaning that lower interest rates have had a minimal effect on the net interest income of the household sector as a whole.
Conversely, in Italy, the drop in household interest earnings has been much larger, as Italian households hold a relatively large amount of interest-bearing assets, whereas they are relatively less indebted. In Spain, the drop in interest payments has been significantly larger than the fall in interest earnings. The larger decline in interest payments in Spain is explained by both the high stock of household debt see Section 4 and the fact that a large share of mortgages have adjustable interest rates.
This is an important factor in the transmission of monetary policy to private consumption, as there is evidence that it has a relatively larger effect in countries with adjustable-rate mortgages. It was also in this period that professional forecasters made the largest upward revisions to their consumption growth forecasts see Chart 2.
The overall decline in oil prices since the second half of has provided households with a windfall gain. Typically, from a historical perspective, consumption reacts with a lag to changes in oil prices.
Since the support from lower oil prices for consumption growth has faded. Going forward, the latest oil price increase between mid and mid is expected to dampen consumer spending somewhat. Notes: The conditional forecast is constructed using the model in Edelstein and Kilian for the euro area.
It shows the model-based forecast of consumption conditional on the observed oil prices. First, increases in household wealth make households richer and therefore also more inclined to consume.
This is the standard wealth effect see also Box 1. As balance sheets are typically weaker during recessions and stronger during expansions, there is a strong link between the strength of the balance sheet and consumption growth. This is the financial accelerator channel. Especially after periods of large increases in leverage, asset price falls can lead to large drops in net worth and generate significant deleveraging pressures that may persistently affect consumption dynamics.
Note: The bank lending survey asks banks how the credit standards applied to the approval of loans to households for consumer credit have changed over the preceding three months. An increase decrease represents a tightening easing in credit standards.
House price changes can have significant accelerator effects on private consumption. The reason for this is that for most households the main residence is their largest asset see Chart Housing wealth also tends to be more evenly distributed than financial wealth, which is mainly held by the top quintile of the wealth distribution. This may explain why, over the business cycle, housing wealth is often found to be more important for private consumption than financial wealth, despite similar direct wealth effects see also the short-run elasticities reported in Box 1.
Note: The amounts in parentheses show the total size of the average portfolio in each quintile. Housing wealth has developed very heterogeneously across euro area countries. While housing wealth in Germany started to increase significantly in , in France it remained virtually flat over the same period see Chart In Italy, housing wealth has declined gradually.
This contrasts with financial wealth, where developments have been much less heterogeneous across countries. Consequently, housing wealth seems also more relevant than financial wealth for explaining persistent cross-country differences in private consumption see Chart 5.
Note: Household real housing wealth is computed as nominal housing wealth divided by the private consumption deflator. Decreasing household indebtedness underscores the sustainability of the expansion in private consumption.
It has been argued that the current economic expansion is less sustainable, as it is based on private consumption and the accumulation of new debt. This does not apply to the current expansion in euro area consumption. In contrast to the period before the crisis, steady euro area consumption growth has been coupled with a gradual decrease in household indebtedness, which in the euro area has now stabilised around its pre-crisis level see Chart Moreover, while certain countries have still seen some increases in household indebtedness towards the euro area average e.
France , cross-country differences have significantly diminished on account of the strong decreases in those countries where the household sector was most indebted e. Note: Based on four-quarter sums of gross disposable income. While the household saving ratio remained low, weak household investment has contributed to further deleveraging.
Chart 19 shows how the low household investment ratio gave rise to a high net lending position of the household sector, reflecting lower household borrowing than before the financial crisis. In contrast with household investment, recent consumption growth does not seem to be affected very much by deleveraging pressures.
Some of this spending, which is counted as C, I, and G, is spent on imported goods. As such, the imports variable M functions as an accounting variable rather than an expenditure variable. To be clear, the purchase of domestic goods and services increases GDP because it increases domestic production, but the purchase of imported goods and services has no direct impact on GDP.
This approach to GDP allows for correct accounting of intermediate goods in a global economy where few goods fall cleanly into the two buckets of being produced either domestically or abroad. In fact, most "domestically produced" goods include some foreign parts or components. It is also important to notice that while C, I, and G measure spending on only final goods and services, exports X and imports M also include intermediate goods.
Exports of intermediate goods also count. While much of the focus in counting GDP is on final goods and services, exports of intermediate goods contribute to GDP. This accounting helps capture the truly global nature of many products.
GDP measures domestic production of final goods and services. The expenditure approach calculates GDP using total spending on domestic goods; but the equation, as stated, can lead to a misunderstanding of how imports affect GDP.
More specifically, the expenditure equation seems to imply that imports reduce economic output. For example, in nearly every quarter since , net exports X — M have been negative see the graph and Table 1 , which seems to imply that trade reduces domestic output and growth. This can influence people's perspective on trade. This essay explains that the imports variable M corrects for the value of imports that have already been counted as personal consumption C , gross private investment I , or government purchases G.
And remember, the purchase of domestic goods and services should increase GDP, but the purchase of imported goods and services should have no direct impact on GDP. A GDP stacking graph shows the contributions of personal consumption expenditures blue , gross private investment red , government purchases purple , and net exports green. Net exports have been negative for nearly every quarter since The visual nature of the graph implies that net exports are a drag on economic growth.
National Income and Product Accounts. The views expressed are those of the author s and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
Intermediate good: A man-made good that is used to produce another good or service, becoming part of that good or service. Stay current with brief essays, scholarly articles, data news, and other information about the economy from the Research Division of the St.
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