The level of consumer confidence is a key determinant of Aggregate Demand. Although consumption primarily depends upon income levels households have the choice of how much of that income they put into savings.
When consumers are uncertain they are cautious. Cautious people save 'just in case'. This has the effect of reducing consumption, Aggregate Deamnd falls and there is slower growth, or worse still a recession. The slow growth alone is enough to convince households they were right to be cautious and recovery becomes difficult.
There are two problems that compound this problem at present.
1. Governments are cutting back on expenditure in order to reduce their debt. Government spending is another component of Aggregate Demand and also has a multiplier effect making the cuts here even more effective in reducing real GDP.
2. The banks are being forced to recapitlise their balance sheets. This is because they have had to write off bad debts and the new rules (Basel Accords) that demand a higher proportion of capital to liabilities. This means the banks take the extra savings they receive in deposits and keep them to raise their capital reserves rather than lend it to firms or consumers.
While many welcome the strenghtening of the banks and the reduction in household debt it is not good for the short term.
It is now clear that consumer confidence is falling in Europe. This is a problem as 60% of UK trade is with other EU memebrs and exports are another compnent of AD.
While the double dip recession remains unlikely rapid growth still seems quite a way off.
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