How does consumption help the economy

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. And paychecks have to flow to productive -- that is value-creating -- behavior, or value is simply being transferred and destroyed.

Instead, employee wages appear in GDP data as consumption when income is spent on final goods like food, clothing, gadgets, and vacations. Moreover, since GDP is an accounting summary, it adds consumption and investment spending together. But this summarizing masks the fact that these two activities are actually in opposition in the short run. In order to invest more today, we have to save more and consume less. Digging below the surface of GDP reveals a structure of value-adding production far more complex than the simplistic analysis given by most media reports.

And since employment is spread across this time structure with relatively few working in final retail stage, savings and investment changes have dramatic impacts on employment.

My wife Lisa and I have personal experience with dynamics that the top-down Keynesian view ignores. Several years ago we launched a side-business designing, manufacturing and selling reusable all-in-one cloth diapers to moms interested in saving money and cutting down on trash. To start the business, we got a small capital contribution from my brother-in-law in exchange for equity in the company.

These savings were put to use buying the raw materials, designing the diaper prints, hiring sets of skilled people both to sew the diapers and to build the website. Designing, testing and producing the product and website took over a year. The time Lisa and I spent building the company was also a very real form of investment itself. When we finally began selling our product to customers, the income generated was barely enough to cover the real costs.

We re-invested all of it into new inventory for the business, keeping nothing for ourselves in the hopes of improving our approach. Investment did. After an additional year of persistent re-investment, we realized that we would need even more investment to make the business viable.

Our costs were too high per diaper and our local production capacity was too low to keep up with demand. Moms loved weehuggers and we struggled to keep the product in stock.

Also, given that households reached record highs both in terms of their relative consumption and debt levels, it seems unlikely that they will go out and increase their borrowing and spending at the same rate as they did in the fourth quarter. Without solid income growth, consumption growth is likely to be slow in the near future.

Check out the archive for past Economic Snapshots. See more work by Christian E. Snapshot for February 6, Business Essentials. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.

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We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Introduction to Economics. Economic Concepts and Theories. Economic Indicators. Real World Economies. Economics Behavioral Economics. What Is Consumer Spending? Key Takeaways Consumer spending is all spending on final goods and services for current personal and household use. Consumer spending is a key driving force in the economy and a critical concept in economic theory.