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

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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...
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