# 16. Private consumption

The shock to private consumption is made by changing consumers behavior, which directly influences consumption. Table 16 presents the effect of a temporary increase in the propensity to consume. Private consumption is increased in year one by a 1000 million kroner, in 2005 prices.

Table 16. The effect of a temporary exogenous increase in private consumption

The shock to private consumption initially works in the same way as a shock to public consumption. Higher private consumption boosts domestic demand; hence private production and employment increase. This creates additional demand for consumption and investment. Imports also increase in the short run as part of the higher domestic demand is met through imports. The higher employment stimulates wage growth and prices and competitiveness fall, leading to a fall in exports.

The effect on employment, production, private and public saving balances, etc is temporary reflecting that the consumption function is an error correction equation, such that consumption adjusts back to the long term value. The adjustment of consumption, however, takes a long time. Consumption remains below the baseline for a long period. This raises wealth and the ratio between income and wealth will back back to the equilibrium value, and consumption returns to the baseline. The initial stimulus to economic activity is sufficient to stimulate wages and hence prices, and it takes time for the higher wage rate to return to the baseline. The crowding out process is illustrated by the fluctuation in unemployment. Unemployment falls initially and this pushes up the wage rate slightly. In year 2, the consumption shock disappears and now the wage is a little too high pulling up unemployment which has to be above the baseline for a while in order to pull the wage rate back down to the baseline. Basically, wages fall relative to the baseline as long as unemployment is above the baseline, so that both unemployment and wage will fluctuate around the baseline on their way back to the baseline. This reflects that the strong link between unemployment and wage change makes unemployment fluctuate, so that the area between unemployment and the baseline converges to zero. It is noted that the basic adjustment process is similar to the adjustment after an overheating of the economy.

The experiment also makes the housing market fluctuate. In the first year, house prices increase sharply because of the higher consumption and this raises housing wealth. Higher housing wealth in turn expands private consumption. The immediate positive impact on house prices triggers a higher Tobin’s q and housing investment increases. Later on, the higher housing capital reduces house price and Tobin's q after the initial increase in consumption disappears. The lower house price drives housing investment and hence housing capital down. In this way, housing capital returns to the baseline. In general, the temporary shock to consumption starts an adjustment process with fluctuations.

Figure 16. The effect of a temporary exogenous increase in private consumption