GDP can be calculated by adding all of the expenditures on new domestic output. Households, businesses, governments, and other nations all spend money in the economy and each is represented in GDP by a different spending variable. Each type of expenditure is subject to various influences, and each can reveal important information about economic activity.
Households engage in personal consumption expenditure. Personal consumption expenditure, or simply consumption, is the act of purchasing goods and services. More than two-thirds of all U.S. GDP expenditures fall under the heading of consumption. In other words, Americans shop to the tune of $9 trillion or more per year for new domestic output.
The ability of households to consume is chiefly constrained by disposable income, which is income after paying taxes. This fact gives government considerable leverage over households’ capacity to consume. When it comes to available disposable income, consumers choose to either spend it in the product market or save it in the financial markets. This means that increased consumption results in less saving, and increased saving leads to decreased consumption.
Consumption is also sensitive to changes in consumers’ wealth, interest rates, and expectations of the future. Increases in consumers’ wealth tend to encourage consumption, while decreases tend to discourage it. The recent implosion of housing prices has had a negative effect on consumers’ wealth. As a result, consumption has declined and saving has increased because consumers are attempting to rebuild their net worth. In addition to housing, much of consumers’ wealth is in the form of retirement accounts. Therefore, changes in the stock market’s key indicators like the Dow Jones Industrial Average and the S&P 500 often indicate the direction of household wealth, and thus consumption.
Durable goods like cars, appliances, and furniture are often purchased using borrowed money. Interest rates are then part of the equation to consume durables. High interest rates discourage durable goods consumption, and lower interest rates tend to encourage the purchase of durable goods. Plans designed to encourage durable goods consumption include 0% financing, interest-free for three years, and no payments until the next year.
Expectations as a determinant of consumption are easily understood. When people fear the future, they tend to save and not make any major purchases. In contrast, people that are upbeat about the future are more inclined to shop and less inclined to save.
Economists recognize that some consumption is independent of disposable income and refer to this as autonomous consumption. During periods of recession, consumption of durable goods is curtailed while consumption of essentials like food, rent, clothing, and healthcare remains relatively unaffected. Do you remember what it was like on September 12, 2001? What type of consumption occurred and what type did not? Chances are that autonomous consumption of necessities and nondurables continued unabated, but consumption of durable goods (except for guns and ammo) and discretionary spending came to a halt.
Households and businesses engage in another expenditure referred to as gross private investment.
It is important to note what investment is not. When it comes to calculating GDP, investment is not the purchase of stocks and bonds. That is financial investment or saving. What is being considered here is real investment. However, this real investment in the economy is financed by the financial investment that occurs in financial markets.
The level of investment in the economy is influenced by expectations of future business conditions and interest rates. Positive expectations tend to boost investment while negative expectations result in less investment. Businesses respond this way in order to have the right amount of productive capacity to meet the expected future demand for their products. Interest rates are also a major consideration in the decision to invest. As interest rates rise, the relative profitability of investment decreases. Decisions to invest compare the expected rate of return to the current interest rate. As long as the expected rate of return exceeds the interest rate, businesses will undertake investment with the expectation of profit. Increased interest rates have the effect of making fewer investments profitable.
Investment is divided into planned and unplanned investment. During periods of economic “normalcy,” businesses invest in capital and in inventory in order to turn around and sell it at a profit. This planned investment assumes that business conditions will continue according to the producers’ expectations. When unplanned investment occurs, it is a sign of bad things to come. Auto dealers order inventory from the factories to sell to consumers. If inventory begins to accumulate, that means consumers are not buying. The dealers stop ordering and the factory stops production. If this halt in production is pervasive, mass unemployment and economic recession occurs.