Expectation and Consumption: How is Consumption Affected by Consumers' Expectation?

No.146
October 2002
Research Fellow Naoki Nagashima

ABSTRACT

It is imperative that Japan accelerate its structural reforms in order to alleviate problems of non-performing bank loans and inefficient operation of governmental institutions. However, with Japan's current confrontation with a long ignored "structural supply and demand gap", there is much friction in the reform process and a very high probability that the process will not be a smooth one. The ideal scenario would be to raise the stagnating consumption demand of recent years while at the same time accelerating structural reform in one motion-without imposing a financial burden on the economy. The atrophy of consumption of the higher income brackets and baby boom generation lies at the root of present consumption stagnation. In particular, baby boomers are now entering an increasingly savings-oriented life cycle and many may be dogged by lowered expectations for the future.

Based on the consideration of the above issues, this report will investigate how the expectation and risk factors of expected income, expected inflation, and income risk affect average consumption tendencies. Through stratified income analysis, the following conclusions can be made.

In relation to consumption tendencies, it is important to note that expected income and expected inflation cannot be reduced to the actual value of income growth rates or inflation rates.
According to scatter plot results, the consumption tendencies of lower income brackets are affected by expected income and income risk, whereas the consumption tendencies of higher income brackets are affected by expected income and expected inflation.
Functional stochastics and time-series analysis conclude that the consumption tendencies of all income groups are affected by expected inflation.
Therefore, the common conclusion that "the tendency for consumption of higher income groups will rise as expected inflation rises" can be made. According to trial calculations on the macroeconomic effect of this policy, if expected inflation rises by one point, consumption will rise by 2.5 trillion yen, and GDP will rise by roughly 0.5%.

If we presume that the baby boom generation suppresses consumption according to their life cycle, then the above analysis allows us to make the following policy implication: "Consumption by the baby boom generation can be accelerated by raising expected inflation". Specifically, "implementation of income tax reduction and measured consumption tax increases targeting luxury consumption" would be an effective set of policies. Revising the ratio of direct to indirect taxes while simultaneously spurring consumption demand in such a way as to avoid incurring additional financial burden is particularly promising.

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