Influences on households' spending, saving and borrowing: income

Micro‑economic Decision‑makers – Households

Objective

To understand how a household’s income and the other four key influences – rate of interest, confidence, age and culture – affect 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 – the primary source for most families.

  • Self‑employment and business profits.

  • Investment income – interest, dividends, rent.

  • Transfers and benefits – state pensions, unemployment benefit, child support.

  • Occasional income – gifts, inheritance.

3. The Five Influences Required by the Syllabus

For each influence the table shows the effect on spending (consumption), saving and borrowing. An exam‑style example follows the table.

InfluenceEffect on SpendingEffect on SavingEffect on Borrowing
IncomeHigher disposable income raises consumption (C = a + bY).Savings increase in absolute terms; the proportion saved may fall because MPC > MPS.When desired consumption exceeds current income, households borrow to smooth consumption.
Rate of interestHigher rates raise the cost of credit, discouraging purchases that rely on borrowing (e.g., houses, cars).Higher rates increase the return on deposits, encouraging saving; lower rates have the opposite effect.Higher rates make credit more expensive, reducing the quantity of borrowing; lower rates stimulate borrowing.
Confidence (Expectations)Optimistic expectations about future earnings or price stability boost current consumption; pessimism does the opposite.High confidence may lower precautionary saving; low confidence raises it.Confident households are more willing to take loans, expecting they can repay; doubtful households avoid borrowing.
AgeYoung households spend a larger share on education, leisure and first‑time housing; older households spend more on health and retirement needs.Savings tend to rise with age – low in early years, peak in middle age, then fall in retirement as savings are drawn down.Younger households often rely on credit for large purchases (e.g., first mortgage); older households borrow less, preferring to use accumulated savings.
CultureCultural values shape preferences for food, clothing, housing and conspicuous consumption.Cultures that value security encourage higher saving rates; cultures that stress generosity or communal support tend to have lower saving rates.In some societies debt is frowned upon, limiting borrowing; in others credit is accepted as a normal part of life.

Exam‑style examples

  • Income: “A rise in a family’s net monthly income from £2,000 to £2,500 is likely to increase their weekly grocery spend and enable them to save an extra £100.”

  • Rate of interest: “If the Bank of England base rate rises from 3 % to 5 %, the monthly repayment on a £150,000 mortgage increases, so the household may postpone buying a new car.”

  • Confidence: “After a positive wage‑growth forecast, a household feels secure and decides to take a personal loan to remodel the kitchen.”

  • Age: “A 25‑year‑old graduate spends most of his disposable income on rent and entertainment, whereas a 65‑year‑old retiree allocates a larger share to medication and pension withdrawals.”

  • Culture: “In a community where extended families live together, households may spend less on housing but more on family celebrations, reflecting cultural priorities.”

4. Income and the Consumption Function

The relationship between disposable income (Y) and consumption (C) is expressed by the consumption function:

C = a + bY

  • a – autonomous consumption: spending that occurs even when income is zero (financed by past savings or borrowing).

  • b – marginal propensity to consume (MPC): the proportion of each additional pound of income that is spent.

Diagram – Consumption Function

Disposable Income (Y)

Consumption (C)

C = a + bY

a (autonomous C)

MPC = b (slope)

5. Saving

Savings are the part of income not spent:

S = Y – C

Substituting the consumption function gives:

S = Y – (a + bY) = –a + (1 – b)Y

  • Marginal propensity to save (MPS) = 1 – MPC.

  • Because MPS + MPC = 1, a higher MPC automatically reduces the proportion saved.

6. Borrowing Decisions

Households borrow when desired consumption exceeds current disposable income. The decision depends on three main factors:

  1. Rate of interest – higher rates increase the cost of credit, reducing the quantity of borrowing; lower rates make borrowing cheaper.

  2. Future‑income expectations (confidence) – optimism about future earnings encourages borrowing, while pessimism discourages it.

  3. Credit availability – the willingness of banks and other lenders to extend credit. (This is an *additional* factor that may be mentioned, but it is not one of the five core influences required by the syllabus.)

7. Factors that Influence Household Income

  1. Employment status – full‑time, part‑time, unemployed, self‑employed.

  2. Education and skills – higher qualifications generally lead to higher wages.

  3. Economic conditions – recessions reduce job opportunities and can depress wages.

  4. Geographic location – urban areas often offer higher‑paying jobs than rural areas.

  5. Government policy – tax rates, minimum wage, welfare benefits and subsidies.

8. Income Effect on Different Types of Goods

Type of GoodIncome EffectTypical Example
Normal goodsDemand rises as income rises.Organic food, branded clothing.
Inferior goodsDemand falls as income rises.Public transport, generic brands.
Luxury goodsDemand increases more than proportionally with income.Designer handbags, high‑end cars.

9. Practical Implications for Policy‑makers

  • Tax cuts increase disposable income, potentially raising consumption and reducing the proportion saved.

  • Interest‑rate reductions lower borrowing costs, encouraging households to finance larger purchases such as homes and cars.

  • Welfare programmes boost income for low‑earning households, who have a high MPC, thus stimulating aggregate demand.

  • Financial‑education initiatives can improve confidence and shift cultural attitudes toward saving and borrowing.

10. Summary Checklist

  • List all five sources of household income.

  • State the five influences required by the syllabus and give a brief explanation of how each affects spending, saving and borrowing (use the table as a guide).

  • Write the consumption function C = a + bY and define a, b, MPC and MPS.

  • Derive the saving function S = Y – C and state that MPS = 1 – MPC.

  • Explain how changes in income affect the demand for normal, inferior and luxury goods.

  • Identify the three main factors that influence borrowing decisions (rate of interest, confidence, credit availability).

  • Recall at least two policy tools that can alter household income or borrowing behaviour.

Suggested diagram: The consumption function showing autonomous consumption (a), the marginal propensity to consume (slope = MPC) and the effect of a change in income on consumption and saving.