FACTORS THAT INFLUENCE SPENDING BY HOUSEHOLDS

Households spend on food, clothing, housing, water, electricity, entertainment, and so on. This
spending is affected by:

1. Disposable Income: This refers to the amount of income that a person has available to spend
on goods and services, after compulsory deductions, e.g. income tax. It is a net income.
Income tax is a direct tax. A rise in disposable income leads to a rise in spending. Thus a rise
in income tax will lead to a fall in disposable income, causing a fall in spending.

Different income levels affect different types of expenditure. E.g. low income earners spend a
greater proportion of their income on food and other necessities, while higher income earners
spend a lower proportion of their income on these. They spend more on luxury goods and
services. Middle income groups spend a lower proportion of their income on necessities
(compared to the lower income groups) and also spend on some luxuries, e.g. jewellery, foreign
holidays and entertainment.

While discussing income, wealth is also considered. Wealth refers to assets held at a point in
time, and which have money value. E.g. shares, residential and commercial property, cars, and
factories. It may also include money held in bank accounts. The wealth of an individual is
measured by the amount of assets they own minus their liabilities (the amount they owe). A
rise in the value of assets creates a positive wealth effect. This causes a rise in spending by
households because they feel richer, their confidence rises, and they can even use their wealth
as collateral to secure a bank loan.

Moreover, wealth creates income for its owners, e.g. dividends earned by shareholders. The
asset can even be sold for money, or the cash withdrawn from a bank account. All these also
lead to a rise in expenditure.

A fall in the value of an asset leads to a negative wealth effect. This can cause people to
experience negative equity, which means that the value of their secured loan / mortgage
exceeds the market value of their property.

2. Interest Rates: The rate of interest refers to the price of money. It is the cost of borrowing
money, or the return on savings held at the bank. A rise in the interest rate increases the cost
of borrowing, causing a fall in borrowing by households. As a result, spending by households
falls. Also, if an individual has an existing loan or mortgage, the rise in the interest rate will
increase the cost of servicing it, leading to a fall in disposable income and a fall in spending.

3. Confidence Levels: High confidence levels lead to a rise in expenditure while low confidence
levels lead to a fall in expenditure. E.g. during an economic recession (when economic growth
rates are negative for 6 months or more), people lack confidence about the future of the
economy. They may fear, e.g. that they may become unemployed. Therefore, they choose to
save rather than spend. The opposite happens during an economic boom, which is a period of
high economic growth.

4. Inflation: This refers to an increase in the general / average price level in an economy. A rise
in inflation leads to a fall in the purchasing power of individuals since their money can afford to
buy fewer goods and services, leading to a fall in spending.

5. Age: A young single person may earn a relatively low income and may spend most of it on
goods and services to support their lifestyle. As a person gets older, their earnings tend to rise
and they start to save a greater proportion of their income to buy a property, start a family, pay
for their children’s university education, and to build up a pension to support themselves when
 they retire. During this phase of life, expenditure falls. After retirement, people spend from their
savings (i.e. they dissave) since they have no earned income.

6. The Size of Households: The larger the household, the higher the expenditure. E.g. a family
with 3 children will usually consume more goods and services than a single-person household.
The average size of households has changed over time. In MEDCs, birth rates are falling since
people opt to marry later in life and have fewer children. There is also an increase in single
households.

SAVING
Saving occurs when a person puts away part of their current income for future spending. It can be
said to be the difference between disposable income and spending. i.e. Saving = Disposable
Income – Spending. People save for the following reasons:

(i) To finance future expenditure, e.g. a holiday, retirement, children’s education, etc.
(ii) To earn interest by saving in a bank.
(iii) To take care of any emergencies, e.g. an accident, job loss, sickness, etc.
(iv) To reach a certain target, e.g. buy a house / car.
(v) To leave an inheritance for one’s children.

FACTORS THAT INFLUENCE SAVING

1. Income: A rise in income leads to a rise in saving. This is because a wealthy person is more
able to save a higher proportion of each extra dollar / shilling earned than a less wealthy person.

2. Rate of Interest: A rise in the rate of interest causes an increase in the returns on savings
held at the bank. As a result, saving increases. For target savers, however, the rise in interest
rates can cause a fall in saving since they can achieve their target amount by saving less.

3. Consumer and Business Confidence: A rise in confidence levels causes a fall in saving as
people are more willing to spend. During an economic downturn, saving increases as consumers
feel less optimistic about the future.

4. Attitudes Towards Saving: These differ between countries. E.g. in the UK and USA, borrowing
rates are very high to fund the purchase of cars and home appliances. The use of credit cards
is very common. On the other hand, credit card use is very low in Japan and Germany. Similarly,
the Chinese are very cautious and prefer to save.

5. Age Structure: The young and the old tend to save less than middle-aged people. In many
economies, people start to save for their future from about the age of 25, when they are more
likely to have secured permanent employment. Thus, the larger the proportion of middle-aged
people in a population, the higher the saving.

6. Tax on Savings: If this is low or zero, it will encourage a rise in saving.

7. The Range and Quality of Financial Institutions: The more these are, the higher the
saving. This is because it will be easier for people to find a saving scheme that suits them. Also,
if the institutions are stable, people will be encouraged to increase saving.
BORROWING
This occurs when an individual, firm or the government takes out a loan, paying it back to the lender
over an agreed period of time, with interest.

Individuals and firms may borrow for the following reasons:

(i) To fund expensive items, e.g. a car or an overseas holiday.
(ii) To fund education.
(iii) To purchase property (e.g. a house or land).
(iv) To start up a new business.
(v) To fund large projects (e.g. business expansion overseas).

FACTORS THAT INFLUENCE BORROWING

1. Rate of Interest: A rise in interest rates causes a rise in the cost of borrowing, making
borrowing more expensive. Thus, borrowing falls.

2. Confidence Levels: A rise in confidence levels leads to a rise in borrowing. E.g. if firms believe
that the economy will perform better in the future, this will encourage them to borrow so that
they can invest in expanding capacity. Similarly, if people expect their income to rise in future,
this will encourage them to borrow and spend more now, knowing that the higher income they
earn in future will make it easier for them to repay the loan.

3. Availability of Loans and Overdrafts: An increase in these makes it easier to borrow, causing
a rise in borrowing. If the central bank decreases the cash reserve ratio (the percentage of a
bank’s assets which must be kept in cash in bank vaults or with the central bank), this makes
more funds available for lending, leading to more money being available for borrowing, and
hence a rise in borrowing.

4. Social Attitudes: In countries where people are very concerned about the risks of getting into
debt, borrowing is low.

5. Wealth: Banks are more willing to lend money to wealthier individuals or more profitable firms.
This is because of their high collateral. Thus, an increase in wealth causes a rise in borrowing.