Introduction
Consumer spending depends on three principal factors. The first is the average or expected income of consumers. The second is the cost and availability of credit.
The third reflects the choice between spending and saving: spend more now and less later, or spend less now and more later. That factor is primarily related to the expected rate of return on assets.
Predicting short-term changes in consumer spending is difficult, both for economists and for managers. The 1990 recession started in July of that year, and income growth, stock prices, and consumer sentiment all declined sharply. As a result, total real consumption fell 0.2% over the next five quarters. The 2001 reces-sion started in March of that year, and, again, income growth, stock prices, and consumer sentiment all declined sharply. Yet over the next year, consumption rose more than 3%.
Quarterly fluctuations in consumption are quite erratic. Changes in disposable income explain less than a quarter of these fluctuations, and changes in monetary variables – the yield spread, change in the money supply, change in stock prices, and change in consumer credit – explain only another quarter. Thus, on a quarterly basis, over half of the fluctuations in consumer spending are due to exogenous or random factors. This poses a major problem to managers of companies that produce consumer goods, and cannot be explained by the use of traditional economic or attitudinal variables.1
As the time horizon lengthens, changes in consumption become more highly correlated with the set of economic variables that includes income, the cost and availability of credit, and asset prices. For example, when the time period is length-ened to one year, about three-quarters of the fluctuations can be explained by these factors, as random events become less important. For a three-year period, about 95% of the changes in consumption can be explained by these variables. Managers must be careful not to overreact to short-term shifts in their own company sales Copyright © 2004 by Michael K. Evans
that are likely to be reversed in the next month or quarter, but should be able to develop longer-term plans for consumer behavior.
This chapter blends the explanation of short-term and long-term changes in con-sumer spending into an overall theory of concon-sumer behavior at the macroeconomic level. All of the factors listed above affect short-term fluctuations in consumption;
in the long run, income and demographic factors emerge as the most important determinants. Changes in the cost and availability of credit, on the other hand, are more likely to impact short-term fluctuations in spending decisions.2
The determinants of consumption are reviewed in greater detail in section 4.1; in the remainder of the chapter, each factor is considered separately. Section 4.2 dis-cusses the relationship between short-term fluctuations in consumption and income and introduces the concept of the marginal propensity to consume. Section 4.3 discusses the relationship between long-term levels of consumption and income, and introduces the concept of the permanent income hypothesis. The ques-tion of whether the impact of changes in tax rates on consumer spending depend on whether the tax changes are temporary or permanent is analyzed in section 4.4.
Several factors dominate short-term changes in consumer spending. Even if consumers would prefer to base their spending patterns on long-term average or expected income, many of them are subject to short-term liquidity constraints, which are discussed in section 4.5; this section also analyzes the impact of changes in the cost of credit. Section 4.6 shows how a decline in interest rates leads to refi-nancing of home mortgages and an increase in housing prices, which permits some homeowners to cash out the additional equity; these factors also boost consump-tion. Section 4.7 discusses the relationship between the expected rate of return on assets and the proportion of income that is saved. Section 4.8 shows that an increase in the ratio of debt to income does not necessarily depress consumer spending.
Turning to the longer-run determinants of consumption, section 4.9 discusses the changes in the consumption/income ratio at different ages in the life cycle, and introduces the concept of the life cycle hypothesis. The role of changes in net worth – both equities and homes – is then considered in section 4.10. Because disposable income excludes realized capital gains, and the gains in income that stem from refi-nancing a home or drawing down increased equity, the concept of spendable income and its impact on consumption is also introduced. The role of consumers’ attitudes is presented in section 4.11. The effect of all these factors on consumer spending is summarized in section 4.12. The chapter concludes with an appendix that traces the historical development of the consumption function.
4.1 Principal determinants of consumption
What macroeconomic factors determine how much of the goods or services produced by your company will be purchased by consumers?
At the microeconomic level, price, quality, service, and distribution channels are all important. We assume these are already well under control. Yet even if the products or services you provide are properly designed, positioned, priced, and distributed, consumers may still fail to buy the expected amount because of macroeconomic conditions. The key factors affecting consumption are:
• Recent average disposable income (DI)
• Expected average DI
• Changes in income tax rates
• Cost and availability of credit
• Demographic factors and age distribution of consumers
• Expected rate of return on assets: debt, equity, and real estate
• Changes in spendable income not included in DI caused by fluctuations in asset prices
• Exogenous shifts in consumer attitudes not related to any of the above variables.
The recent level of disposable income is the single most important factor affecting consumer spending at both the macro and micro level, although even that is not an unerring indicator. Most of the time, when income is rising faster than usual, consumption will rise faster than usual; during years of sluggish growth or actual declines in income, consumer spending will also be sluggish or decline. In general, someone with disposable income of $100,000 per year spends about twice as much as someone with disposable income of $50,000. In any given year, employees who receive a big raise will generally boost their consumption by more than people who receive a small raise or none at all; and those suffering pay cuts or losing their jobs will diminish their consumption, although not by as much as income has fallen. A tax cut will boost consumption, and a tax increase will reduce consump-tion, although the impact will be larger if the tax change is permanent rather than temporary.
In the long run, the relationship between consumption and disposable income is almost proportional. In the short run, however, the relationship between changes in consumption this period and changes in income is not highly correlated, as shown later in figure 4.1. The reasons for this lack of correlation between consumption and income are discussed later in this chapter. The empirical evidence shows that:
• In the long run, the ratio of consumption to income is almost constant, although the reported ratio has risen in recent years because of deficiencies in measuring disposable income.
• In the short run, changes in consumption are not closely correlated with changes in income for several reasons. Consumption is based on average or expected (rather than current) income; this is often known as the permanent income hypothesis. Attitudes may frequently shift. Also, the cost and availability of credit are likely to influence consumer spending decisions in the short run. In
particular, a decline in income might not reduce consumption if it is accompanied by lower cost or increased availability of credit.
• Except for recessions, short-run changes in income are generally accompanied by smaller changes in consumption. That is particularly true if the changes in income are unexpected. During recessions, though, changes in income are usu-ally accompanied by proportionately larger changes in consumption, reflecting decreased expectations.
• Changes in realized capital gains are not included in disposable income, although they affect consumption. A reduction in mortgage rates that results in refinanc-ing will increase the amount of income available to spend on other goods and services. Similarly, an appreciation in the price of a house may induce some fam-ilies to refinance with a larger mortgage and spend the extra cash; since 1990, that has been an increasingly important source of income for consumer spend-ing. These factors are all significant, but none of them is included in measured disposable income, which is the major reason the reported personal saving rate declined so much during the 1990s.
• Many consumers face a short-term borrowing constraint whenever planned con-sumption exceeds actual income, since the average consumer holds relatively few liquid assets. Hence when the availability of credit diminishes, consumption is likely to decline much more than indicated by income, attitudes, or the cost of credit.
For all these reasons, short-term changes in consumption and income are not very highly correlated. This can lead to unexpected fluctuations in retail sales, affecting manufacturers and retailers alike. It can also make successful fiscal policy planning difficult.
Before the 1930s, economic theory generally did not include a separate con-sumption function; emphasis was placed on the equivalence between saving and investment. When the consumption function was first introduced, it was claimed that consumer spending was primarily tied to current income, and that the saving rate rose as income increased. The historical development of the modern con-sumption function, in which the principal arguments are ‘‘permanent’’ income, monetary conditions, and life cycle variables, is presented in the appendix. The modern consumption function is based on the following concepts:
1. Consumers base their spending patterns on their permanent or long-term expected income, rather than income in this quarter or year.
2. Consumers will change their spending patterns more if a change in income is perceived to be permanent rather than temporary.
3. Consumers are likely to spend a higher proportion of their income if they are optimistic about the future. That is most likely to happen when the unemploy-ment rate is low, the inflation rate is low and stable, and the stock market is booming.
4. At any given level of income, consumers will base their spending plans in part on expected future changes in consumption and income. For example, many
parents save in order to send their children to college. They will dissave dur-ing those college years, save for retirement, then dissave again once they have retired. New college graduates often spend more than their current income to furnish a house or apartment, since they expect their income to rise rapidly over the next few years. This does not mean consumers can forecast the future better than anyone else, but they can make intelligent choices about what is likely to happen over their life cycle.
5. Financial variables are important in determining the timing of consumption in the short run. While changes in the cost of credit – interest rates – do affect consumption, the main linkage occurs because most consumers are subject to a borrowing restraint. Thus even if it would make sense for consumers to spend more now because their income will probably increase sharply in the near future, they might not be able to borrow the money right now.
6. Changes in stock prices affect consumption in opposite ways. To a certain extent, an increase in the stock of wealth might mean consumers spend more of their current income. Also, a rise in stock prices creates capital gains, some of which could be spent. Conversely, if consumers expect rapid gains in the stock market, they might decide to save more now in order to be able to spend more later – and if the stock market is expected to fall, they might decide to spend more now.
7. Since 1980, the reported personal saving rate has been closely correlated with interest rates. That is mainly because a lower interest rate boosts the value of the stock market, increases the value of one’s home, permits refinancing mortgages at lower interest rates, and is generally accompanied by easier credit terms.