2011 May HL TZ1 Q2

During the global financial crisis of 2008–2009, there was a fall in consumer spending
in many countries.
(a) Explain the factors which might be responsible for causing consumer spending to
fall.

Model answer
(Introduction and Definition) Consumer Spending sometimes refers to as Consumption is
defined as all the spending done by households on goods and services. The level of consumer
spending in a nation depends on several factors.

Consumer Spending(C) is also one of the four components of an Aggregate Demand (AD) which is
defined as the total planned expenditure for the output (Real GDP) of a nation at a range of
overall price levels in a particular period of time from all consumers, domestic and foreign.
(Ceteris paribus)
So that a fall in consumer spending will lead to a fall in AD as shown on a diagram, at any price
level, AD will shift to the left followed by a decrease in consumer spending leading to a decrease
in national income Y and total output measured in real GDP.

Average
Price Level

PL1

AD2 AD1

Y1 Y2 Real GDP

The value of existing wealth (real assets and financial assets) is first factor that affect consumer
spending. During the 2008-2009 financial crisis, the shock in real estate and stock markets caused
the price of securities and houses to fall leading to a decrease in consumers’ propensity to
consume. Referring to the diagram above, a shift in AD is likely to occur.

Household’s indebtedness is another important factor that may cause consumer spending to fall.
During financial crisis, deleverage of the debts (paying money back to banks) may reduce
consumers ability to consume thus lead to a decrease in consumption and shift AD to the left.

The above two factors will further affect consumer confidence, their expectation of future
income, thus worsen the situation of insufficient spending currently.

Apart from the factors mentioned above, the rest two spending related factors: consumer
income tax and real interest rate are likely to be low, for the purpose that government may want
to encourage spending. There is time lag effect (time delayed for the society to response to a
policy move) for the policy related factor to activate, thus we can minimize their influence on
consumer spending.

To sum up, value of existing wealth, indebtedness and confidence is the major factors cause
consumer spending to fall in 2008 crisis, the income tax and interest rate factors may encourage
spending assuming the government has realized the crisis: it takes a while for the society to give a
desired response.