Influences on households' spending, saving and borrowing: income

Micro‑economic Decision‑makers – Households

Objective

To understand how a household’s income influences its decisions to spend, save and borrow.

1. What is a household?

A household is a unit of consumption consisting of one or more individuals who share resources and make joint decisions about the use of income.

2. Sources of Household Income

• Wages and salaries (primary source for most families)
• Self‑employment and business profits
• Investment income (interest, dividends, rent)
• Transfers and benefits (state pensions, unemployment benefits, child support)
• Other occasional income (gifts, inheritance)

3. How Income Affects Household Decisions

3.1 Spending (Consumption)

The relationship between income (Y) and consumption (C) can be expressed by the consumption function:

\$C = a + bY\$

where:

• \$a\$ = autonomous consumption (spending when income is zero)
• \$b\$ = marginal propensity to consume (MPC), the proportion of each additional dollar of income that is spent.

3.2 Saving

Savings (S) are the part of income not spent:

\$S = Y - C\$

Substituting the consumption function gives:

\$S = Y - (a + bY) = -a + (1-b)Y\$

Thus the marginal propensity to save (MPS) is \$1-b\$.

3.3 Borrowing

When desired consumption exceeds current disposable income, households may borrow. The decision to borrow depends on:

• Interest rates – higher rates increase the cost of borrowing.
• Future income expectations – confidence that future earnings will cover repayments.
• Credit availability – willingness of banks to lend.

4. Factors that Influence Household Income

1. Employment status – full‑time, part‑time, unemployed.
2. Education and skills – higher qualifications generally lead to higher wages.
3. Economic conditions – recession reduces job opportunities and wages.
4. Geographic location – urban areas often offer higher-paying jobs.
5. Government policy – tax rates, minimum wage, welfare benefits.

5. The Income Effect on Different Types of Goods

6. Practical Implications for Policy Makers

• Tax cuts increase disposable income, potentially raising consumption and reducing saving.
• Interest‑rate reductions lower borrowing costs, encouraging households to finance larger purchases.
• Welfare programmes boost income for low‑earning households, who have a high MPC, thus stimulating demand.

7. Summary Checklist

• Identify all sources of a household’s income.
• Understand the consumption function and the concepts of MPC and MPS.
• Explain how changes in income affect spending, saving and borrowing decisions.
• Recognise the role of external factors (interest rates, credit availability, expectations) in borrowing.
• Distinguish between normal, inferior and luxury goods in relation to income changes.