What Is the Importance of Consumption Expenditure in Determining Changes in the Level of National Income?

What is the importance of consumption expenditure in determining changes in the level of national income?

In every macroeconomic question, there always exists its direction towards satisfying the macroeconomic objectives such as achieving long term economic growth and low unemployment levels (Hall and Lieberman, 2009). As consumption expenditure is the total spending by consumers on domestic goods and services, and national income is the value of all the goods and services provided in an economy in a given time period, normally over one year, the relationship between these two will be established though the expenditure approach and the Circular Flow of Income (Ian and Blink, 2007; Sexton 2007). In addition, consumers’ expectations of the future and its influence on national income will be explained, thus reflecting the importance of consumption expenditure in determining levels of national income (Keynes, 2008).

Through the expenditure approach, which is the calculation of national income (NY) by adding expenditure by market participants on final goods and services over a given period, economists separate spending into 4 different categories, mainly Consumption (C), Investments (I), Government Spending (G), and Net exports which equals to Exports (X) minus imports (M). Therefore, according to this approach, NY=C+I+G+(X–M). (Sexton, 2008)

In basic terms, the Circular Flow of Income shows “how from year to year the income earned producing things enables people to buy these things, and thereby permit the process to continue in a never-ending circular flow of income earning and spending.” (Kennedy 2000, pg. 72)

Figure 1: The Circular Flow of Income (Closed Economy)
Firms
Households
Factors of Production (1)
Goods and Services (3)
Expenditure on Goods and Services (4)
Wages, rent, interest and profits (2)

Source: Adapted from Ian and Blink (2007)

Figure 2: The Circular Flow of Income (Open Economy)

Households

Investment (I)
Saving (S)

Exports (X)
Imports (M)
Income
Expenditure

Firms

Government spending (G)
Taxes (T)

Leakages
(W)
Injections
(J)

Source: Adapted from Ian and Blink (2007)

In Figure 1, the Circular Flow of Income of a closed economy shows that “Households” provide the factors of production, i.e. land, labour, capital and entrepreneurship to “Firms” (1) and in turn receive income from them though rent, wages, interest and profits respectively (2). In addition, they buy goods and services from Firms with their received income (4) and this income goes to the firms (3). The cycle continues as the money circulates throughout the economy (Ian and Blink, 2007).

In Figure 2, the Circular Flow of Income of an open economy with Leakages and Injections is introduced because this is a more accurate reflection of the realities of the world since economies do not exist based on just Households and Firms (Ian and Blink, 2007). With consumers saving part of their income for use of future consumption and part of their income is taxed to go to the government, and the existence of trade which allows expenditure on foreign products, S, T and M are thus considered the 3 main components of Leakages, respectively (Murad, 1962). I, G and X make up Injections because Firms are able to assess Household’s Savings through bank loans to increase production, adding to expenditure, the Government is any economy’s largest consumer and through trade comes the selling of domestic products overseas, respectively (Ian and Blink, 2007).

With the establishment of the information above, consumption expenditure is important to national income because “it is the sole end and object of all economic activity” (Keynes 2008, p.95). This will be shown through the multiplier effect, accompanied with the marginal propensity to consume (mpc), hence determining the degree of fluctuations in NY. The multiplier effect is defined as a “chain reaction of additional income and purchases that results in total purchases that are greater than the initial increase in purchases” and the mpc is the relation between an increase in a consumer’s consumption and an increase in his income (Sexton 2008, p.964; Keynes, 2008). With the Injection of I of £10million, NY would immediately increase by £10million. Given that the mpc has a value of 0.5, the first group of consumers who receive this amount of money would have their income raised by £10million because of the direct relationship NY and C share in the equation: NY=C+I+G+(X–M). However, with an mpc of 0.5, C rises by £10million x 0.5 = £5million and this would go to the second group of consumers who would spend £5million x 0.5 = £2.5million. During each round, 50% of income is spent, while the other half is withdrawn as S, T and/or M (Mankiw, 2009). This cycle continues until the initial Injection of £10million is eroded away and the economy has reached a new equilibrium with a rise in £25million (Ian and Blink, 2007).

The calculation of the multiplier is shown below:

1/(1–mpc) = 1/(1–0.5) = 2.5

Taking this value, multiplied by the initial Injection would show the eventual increase in NY (Ian and Blink, 2007). Therefore, as long as C takes up a huge percentage in any economy’s NY, it would play a vital role in determining a country’s NY levels.

However, this is with the assumption that the economy is not near or at full employment, as a rise in C would bring about inflation, due to the high degree of resource utilization, that is, the need to use more labour with increase in NY level (Keynes, 2008).

In addition, C is important because it is the only component that can change in a closed economy. In the equation where NY=C+I+G+(X–M) which can be further simplified to NY=C+J, and with a closed economy in operation, the absence of Injections or Withdrawals only renders C useful in influencing NY levels because it can be assumed that a new closed equilibrium of an economy is reached after undergoing the multiplier effect (Sexton, 2008).

Nevertheless, C is also susceptible to certain factors that could cause NY levels to decrease. According to Keynes (2008), C is easily affected by consumer’s expectations of the future. Rising economic growth could form a basis for future disposable income to increase thereby encouraging current expenditure, and thus stimulating the economy. With the best information available, accompanied by the multiplier effect, rational expectations would increase NY levels further (Kennedy, 2000). However, if the outlook of the economy is bleak, consumers are likely to expect low returns, regardless of their investments in shares or a decrease in disposable income. Thus, they may channel income towards less liquid forms of cash such as properties, reducing the flow of liquid cash in the economy, contracting the circular flow of income and result in the economy’s decline due to decrease in NY level (Ian and Blink, 2007).

In conclusion, consumption expenditure is important in determining the changes in national income because it makes up a huge component of NY, out of the other components and is the only component capable of influencing NY levels in a closed economy. Through the multiplier effect and mpc, C is shown to be highly influential in aiding an economy’s achievement of macroeconomic aims such as long term economic growth and a low unemployment level. However, it is also easily affected by consumer’s expectations of the future because they can cause sudden and violent changes to consumption expenditure. Therefore, it is advisable for governments to implement policies to stimulate the other components of NY as well to optimise an economy’s performance in the world.

(1083 words)

Reference List

1) Dorton, I. and Blink, J., (2007). Economics Course Companion. New York: Oxford University Press 2) Hall, R.E. and Liberman, M., (2009). Business & Economics. USA: Cengage Learning 3) Kennedy, P., (2000). Macroeconomic essentials: understanding economics in the news. 2nd edition. USA: Massachusetts Institute of Technology 4) Keynes, J.M., (2008). The General Theory of Employment, Interest and Money. India: Atlantic Publishers and Distributors (P) Ltd. 5) Mankiw, N.G., (2009). Principles of Macroeconomics. 5th Edition. USA: South-Western Cengage Learning. 6) Murad, A., (1962). What Keynes Means. USA: Bookman Associates. Inc. 7) Sexton, R.L., (2008). The Exploration of Economics. 4th edition. China: Thomson South-Western