According to the Keynesian consumption function, personal consumption expenditures of households, referred to as consumption in this paper, is a function of GDP (Keynes, pp. 89-134). In recent years, "consumer expenditures have accounted for nearly 70% of aggregate expenditures in the United States," (Thomas, pg. 588). Services, nondurable goods, and durable goods are the factors of consumption. These expenditures may be influenced through a number of channels, such as interest rates affecting spending on durable goods, a change in wealth affecting all factors of consumption, and the effect of a change in liquidity on spending for durable goods.
Durable goods, a factor of consumption, represents spending on such long lasting items as cars, airplanes, televisions, etc. As consumption gradually rose through the decades, expenditures on durable goods remained relatively constant at around 8.3% of GDP throughout the 1980’s and 1990’s. Recent favorable conditions in the equity and bond markets reassure consumers of increases in expected average future income and expected future wealth. Feeling confident they will not need to convert savings portfolios to cash in the near term, consumers are demanding more durable goods. Durable goods are not easily convertible to cash. Purchase of these long lasting big-ticket items represents consumer confidence in future earnings.
Inflation is the weakening of purchasing power. Consumers fear this condition because it dilutes their wealth and ability to consume. The labor market "is at a drum-tight 4.3%, and that is taking its toll on firms’ ability to find suitable workers" (Naroff and White, p. 1). As demand for consumption increases, so does the pressure to meet that demand, creating an induced demand for labor services. As labor becomes scarce, the price of labor increases.
When firms pay more for labor, they lose profits and must pass the higher costs of production to consumers, fueling inflation. This forecast will hopefully predict a slowing in consumption and thus ease concern over future inflationary times.
The rest of the paper is organized as follows: Part 2 presents the data
used to forecast cosumption; Part 3 presents the theoretical basis for
the approach adopted in forecasting consumption; Part 4 presents forecasts
of consumption for 1999 and 2000; Part 5 evaluates the importance of the
forecast for the economy; and Part 6 presents conclusions.
Data were obtained for real expenditures for durable goods (PCEDGC92),
industrial production (INDPRO1992=100), and consumption spending (PCEC92).
The consumption function of the Keynesian Aggregate Expenditures Model
is used to explain the relationship of consumption to aggregate expenditures
and expenditures on durable goods. The Federal Reserve Bank of St. Louis
Federal Reserve Economic Data (FRED) is the source for variables used in
this project. Data sets begin the first month of 1992, ends the twelfth
month of 1998, and forecasts to the twelfth month of 2000. All data are
measured in billions of chained 1992 dollars with seasonally adjusted annual
rates. Though expenditures on nondurable items and services could also
be used in the equation, movement in these areas is more volatile than
durable goods. The relatively constant portion of expenditures on durable
goods should act as a stabilizing agent in the forecast.
This forecast assumes expenditures on durable goods will be a predictor
of future consumption spending as a whole. Durable goods expenditures indicate
disposable income and consumer confidence. A further assumption is that
recent growth rates in industrial production will remain relatively stable.
This assumption allows for an accurate forecast over the next 24 months,
into the years 1999 and 2000. The Keynesian consumption function is:
According to Keynesian theory, "the economy tends toward an ‘equilibrium’ level of production dictated by aggregate spending" (Oyen, pg. 168). This statement is commonly known as the aggregate expenditures model and it underlines the assumption that when aggregate expenditures is greater than production, production increases.
Durable goods are an accurate indicator of the consumer's confidence in the economy and their perceptions of its continued performance. The average annual growth rates for industrial production and consumption of durable goods will be used to project consumption over our forecast horizon of two years. The level of consumption in the predicted years will signal whether or not to expect inflation.
Adding real durable goods consumption as an explanatory variable, substituting
the index of industrial production for real GDP, and lagging the right-hand-side
variables 24 months (two years), and the consumption function can be written
as a forecasting equation:
This equation is the basis for the forecast presented in Part 4.
The forecasting equation based on the consumption function
was estimated with 1992.1 through 1998.12 monthly data. The regression
estimate is (t-statistics in parentheses):
The slowing increase in consumption spending indicates consumers are
taking a more realistic approach towards economic growth. The slight slowdown
may not be noticeable to the average person because the gain will still
be above average and is indicative of a strong and stable economy.
Real consumption is predicted to rise at approximately 3.4 % per year.
Assuming the forecast turns out to be correct, increasing durable goods
consumption indicates a higher level of future output. An outside factor
to consider would also be the wealth effect, which suggests higher durable
goods spending may result from greater personal wealth. As the stock market
booms along, people find their net worth increasing and have more wealth
to finance consumption.
Keynes, John Maynard, The General Theory of Employment Interest and Money, New York: Harcourt Brace and World, 1936.
Oyen, Duane B., Business Fluctuations and Forecasting, New York, Dearborn Financial Publishing, 1991, pp. 18, 168.
Naroff, Joel L. and White, Veronika, "No Fed. Lots of Jobs!" http://www.firstunion.com/, First Union Weekly Economic Commentary, February 1999, p. 1.
Thomas, Lloyd B., Jr., Money, Banking, and Financial Markets, New York, McGraw-Hill, 1996, p. 588.