Decomposing US household consumption
Linking labour market dynamics to domestic demand
Welcome. Today’s post is about another short and simple algebraic trick to help economists extract insight from data. What makes it most interesting is that it is based on arguably well-standardised labour market and national accounts time series across many countries. Let’s break down household consumption from the bottom-up.
I am going to use the United States as an example, as everything shown here comes from FRED data which can be easily sourced using their very convenient Excel Add-In. This is also one of those posts where I share a spreadsheet for in this link. So without any further ado, let’s state the model.
The model
Step 1: We state the budget constraint, household consumption "C" is real disposable income "RPDI" scaled down by a savings rate "s".
Step 2: We break down disposable income as employment "E", wages "W" scaled by other income from gov't transfers, payroll taxes, capital earnings, remittances as "oi" (measured as share of wages) and the price level "P".
Step 3: We break down employment further into woking age population "Pw", the labor participation rate "Part" and scale it down by the unemployment rate "u".
Step 4: We plug equations 3 and 2 into equation 1.
Step 5: We take logs from both sides of the equation and then subtract it by its previous period (as in first differences). If you know a little bit of math, you will remember that log changes are approximately equal to percentage growth changes, which is convenient.
Lastly, we aggregate components to suit our analysis. I am going to propose two possible setups in this post:
Thus we have a model. Now we need to source our numbers.
The data
As the post’s focus is more about explaining the method than investigating interesting country cases, we’re going to work on US data for no other reason than convenience. It is the economy everyone talks about most often after all.
The spreadsheet attached to this post will carry all the details, but some are worth pointing out as they are specific to the US.
The Bureau of Economic Analysis (BEA) defines working age population as persons 16 years of age or older and computes its participation rate from those that are currently working or actively looking for a job within that age bracket. This is slightly different than most other countries, which stick to persons at age 15-64 as a standard. This detail should be accounted for in the analysis as it will affect contributions perceived by demographics (from aging population) and participation rates (labour supply);
The US government usually takes more than it gives back in terms of income to its population. But this is not the case for many other countries which tax capital earnings and consumption in order to provide income in the form of government transfers and pensions. This is why the definition of “Other income / Taxes” is purposefully dubious, signs can go either way here and will depend heavily on public policy;
Savings can’t usually be explicitly observed in data, but we can calculate by what is implied from consumption in the form of expenditures and disposable income data. In this exercise the savings rate is solved as a residual from equation 1, as in s=(1-C/RPDI).
Data caveats aside, we can move on to results.
Results
As explained in the model section, there are many ways in which we can add back our pieces together to suit an analysis, the following charts will stick with the two I proposed initially, I do recommend changing things around. Everything is valid as long as identities are properly respected.
Chart 1 - Nominal aggregate labour income vs. inflation
The benefit of this first chart is that it helps showing the extent to which inflation erodes real wages and detracts from household consumption. Labour income aggregates all labour along with demographic dynamics, useful if you just want to brush through the labour market story.
Chart 2 - How labour market dynamics affect demand
This second chart is probably useful for deeper dives into the labour market, as it will strip unemployment and labour supply contributions to consumption (i.e. domestic demand) more explicitly. Most take for granted how significant a role demographics play in the real economy, but the ultimate importance of any market is the amount of people willing to work and consume in it.
Concluding thoughts
It plays to the strength of this analysis that it is flexible and simple enough for most. I have done more complicated posts in the past, so took a few steps back and decided to bring something lighter yet still useful this time.
This is it for today’s entry. Thank you for making it this far. If you enjoyed this content please don’t forget to like, subscribe and share. Makes a world of a difference to me knowing that the content has hit the nail on the head as we develop this writer/reader relationship further.