Households | IGCSE Class 10 Economics Notes

This note covers the factors that influence household spending, saving and borrowing: income, the rate of interest and confidence; and how these influences differ between different households and change over time.

What is a household and why do its spending, saving and borrowing decisions matter?

A household is a single person or a group of people who live together and make joint decisions about spending, saving and borrowing.

Households are one of the main decision-making units in an economy: they earn income by supplying labour and other factors of production, and they decide how much of that income to spend now, how much to save for later, and how much extra to borrow.

These three decisions, spending, saving and borrowing, are linked. A household's consumption expenditure is the amount it spends on goods and services.

What is not spent out of income is saved, and if a household wishes to spend more than its income allows, it must borrow using credit.

Credit refers to an arrangement in which a lender supplies money, goods or services now in return for a promise of future repayment, usually with interest added.

Three influences matter most for how households spend, save and borrow: their income, the rate of interest they can earn on savings or must pay on loans, and their confidence about the future.

Each of these can differ sharply between one household and another, and can change for the same household over time, for example as its income rises, as interest rates move, or as the economy moves from a boom into a slowdown.

How does income influence household spending, saving and borrowing?

Income is usually the strongest influence on a household's spending and saving. Disposable income is the income a household has left after direct taxes have been deducted and any state benefits added; it is this income, not gross income, that a household actually has available to spend or save.

As income rises, total spending generally rises too, but not by the same amount. A larger income usually leaves room for more saving, because a household's essential spending on food, housing and other necessities does not rise in the same proportion as income.

The proportion of income that is saved is called the saving ratio: saving as a percentage of income.

Lower-income and higher-income households

Lower-income households tend to spend a higher proportion of their income on necessities and save little, if anything; some may need to borrow simply to cover day-to-day living costs.

Higher-income households can meet their necessities comfortably and have more income left over, so they are able to save a larger proportion of income and are less likely to need to borrow for everyday spending.

Income also affects borrowing because lenders look closely at a household's income and its stability before agreeing to lend. A documented, regular income makes it easier for a household to be approved for credit and to be offered more favourable terms.

How does the rate of interest influence household saving and borrowing?

Definition: Rate of interest. The rate of interest is the price of borrowed money: the percentage of a loan that a borrower must pay to a lender each year, or the percentage return a saver earns on money deposited or lent.

Every loan agreement specifies an interest rate that the borrower must pay to the lender in addition to repaying the original amount borrowed, known as the principal.

The interest rate, together with any collateral required, the documentation needed and the method and timing of repayment, make up what are called the terms of credit.

Definition: Collateral. Collateral is an asset the borrower owns, such as land, a building, a vehicle or a bank deposit, that is used as a guarantee to the lender until the loan is repaid; if the borrower fails to repay, the lender has the right to sell the collateral to recover the money owed.

A rise in the rate of interest has two opposite effects. For savers, a higher interest rate makes saving more attractive, since money left in a savings account earns more, so households tend to save a larger share of income.

For borrowers, a higher interest rate raises the cost of a loan, since more must be repaid on top of the principal, so households tend to borrow less and may delay spending on expensive items bought on credit, such as durable goods like vehicles, furniture or household appliances that are used repeatedly over several years.

A simple example shows how the rate of interest shapes a household's decision to borrow.

Sara took a loan of $50,000 from a bank to buy a house, at an annual interest rate of 12 per cent, to be repaid over 10 years in monthly instalments; the bank required proof of her employment and salary, and kept the papers of the new house as collateral until the loan was fully repaid.

A lower rate of interest, or easier collateral and documentation requirements, would have made this loan cheaper and easier for Sara to obtain; a higher rate, or stricter requirements, would have made her less likely to borrow at all.

A fall in the rate of interest works the other way: saving becomes less rewarding, so households save a smaller proportion of income, while borrowing becomes cheaper, so households are more willing to take on loans to finance spending, for example on housing, vehicles or starting a small business.

How does confidence influence household spending, saving and borrowing?

Definition: Confidence. Confidence is how optimistic or pessimistic households feel about their own future income and job security, and about the state of the economy generally.

When households are confident that their income will stay secure or rise, for example because employment is widely available and wages are rising, they are more willing to spend a larger share of current income, including on durable goods bought on credit, and are more willing to borrow to finance major purchases such as a house.

Confident households may also feel less need to build up large savings as a precaution, because they expect to be able to earn and borrow in future if needed.

When confidence falls, for example because households fear rising unemployment, falling wages or a worsening economic outlook, households typically cut back on non-essential spending, increase precautionary saving (saving built up as a safeguard against an uncertain future, such as possible illness, job loss or a bad harvest), and become more reluctant to take on new debt, since they are less sure they will be able to repay it.

Confidence also affects how risky borrowing feels. A loan that helps a household to increase its future earnings, such as a working-capital loan to expand production on time, can leave the borrower better off.

But if the income expected to repay the loan fails to appear, for example because a harvest is destroyed by pests, the borrower can be pushed into a debt trap, a situation in which a borrower is unable to repay a loan from income and has to borrow further or sell assets, leaving them worse off than before.

Fear of this outcome reduces households' confidence about borrowing, especially where their income is uncertain.

How do spending, saving and borrowing differ between households?

Households with different incomes, assets and circumstances make different decisions, even when they want to save or borrow for similar reasons. The same three influences, income, the rate of interest and confidence, act on every household, but they act with different force because households start from different positions.

How does income produce different spending and saving outcomes?

A lower-income household spends a high proportion of its income on necessities such as food, rent and fuel, and saves little or nothing. Any rise in the price of necessities forces it to cut other spending, and an unexpected expense may force it to borrow simply to cover day-to-day living costs.

A higher-income household covers its necessities easily and has income left over, so it can save a larger proportion of income and can afford to spend on non-essential goods and services, such as holidays, entertainment and better-quality food.

Two households on the same income can still behave differently. A household with several young children typically spends more and saves less than a single person on the same income, because its essential outgoings are higher. A household that expects its income to fall, for example because the main earner is nearing retirement, may save more than a household of the same income that expects steady work ahead.

How does the rate of interest produce different outcomes?

A rise in the rate of interest helps households that already hold savings and hurts households that owe money. A richer household with a large balance in a savings account earns more interest income and may save even more. A poorer household with an outstanding loan, or one that borrows each month to cover bills, must pay more interest and has less left to spend.

For this reason the same change in the rate of interest can raise saving in one household and cut spending in another, and the gap between the two widens.

How does confidence produce different outcomes?

Confidence matters most where the household has least cushion. A household with secure salaried work and savings can ride out a spell of bad news without changing its plans much. A household whose income is uncertain, such as a self-employed trader or a casual worker, is more likely to cut non-essential spending and to increase precautionary saving at the first sign of trouble, because it has no savings to fall back on.

Confidence also affects borrowing differently. A household that is confident of rising income may borrow to buy a house or a vehicle; a household that fears losing its income will avoid new debt even if the loan is cheap.

Why do borrowing terms differ between households?

Households also differ in what they must pay to borrow. A household that can offer collateral, such as a house or a deposit, and can show steady income through documents, is usually offered a lower interest rate and a longer repayment period. A household without such assets or records is usually charged a higher interest rate, or can borrow only from a lender who knows it personally.

These differences in the terms of credit mean that two households borrowing for the same purpose, such as buying a vehicle or meeting a large bill, can face very different costs, and the household with the higher cost has less income left for itself.

For any household, the terms of credit, not just whether credit exists, decide whether borrowing helps a household or harms it: cheap, well-matched credit can raise a household's income, while dear, poorly matched credit can push it into a debt trap.

How do these influences change over time?

For any one household, income, interest rates and confidence all tend to change over a person's lifetime and over the wider business cycle, altering spending, saving and borrowing decisions.

Over a household's life, income typically rises during working years, often making borrowing for a house or other durable goods affordable at that stage, and saving tends to build up as earnings grow and as households plan for retirement, when income usually falls and saving is often drawn down instead.

A household that takes repeated short-term credit, such as a farmer taking a fresh loan each season, may see its position change markedly from one year to the next: a good season allows a loan to be repaid and a profit made, while a failed season can leave an unpaid debt that grows, forcing further borrowing or the sale of assets.

Over the wider economic cycle (the repeated rise and fall of economic activity between periods of growth, or boom, and periods of slower growth or decline, called recession), interest rates set by a country's central bank often change as policy responds to the state of the economy, and confidence tends to rise in a boom and fall in a recession.

During a boom, rising confidence and often lower borrowing costs tend to encourage households to spend more and borrow more; during a recession, falling confidence and job insecurity tend to make households cut spending, build up precautionary saving and reduce borrowing, even if interest rates fall to try to encourage spending.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

How do formal and informal credit differ?

Formal sector credit refers to loans from a bank or cooperative societies, which are supervised by a central bank and generally charge comparatively lower interest rates.

Informal sector credit refers to loans from a moneylender, trader, landlord, employer, relative or friend, which are not supervised by any central authority and typically charge much higher interest rates.

Lenders in the informal sector are free to charge whatever interest rate they choose, and there is no body to prevent unfair practices in recovering the money.

Note: Richer households can usually offer the collateral and documentation that formal lenders require, so they can access cheaper formal credit; poorer households, who often lack assets to pledge as collateral, rely more heavily on expensive informal credit.

Because higher interest rates on informal loans absorb a larger share of a poorer household's earnings, higher borrowing costs leave poorer households with less income left for themselves, and raise the risk that they fall into a debt trap, compared with richer households borrowing cheaply from the formal sector.

How do the terms of credit vary between borrowers?

Recorded examples from one village show how income and collateral together determine the terms of credit different households receive.

A small farmer with 1.5 acres of land had to borrow from a moneylender at an interest rate of five per cent a month (equivalent to 60 per cent a year), and later from an agricultural trader at three per cent a month, who also required the farmer to sell his crop to the trader at harvest.

A farmer with seven acres of land in the same village was one of the few people able to obtain a bank loan, at only 8.5 per cent a year, repayable within three years.

A landless agricultural labourer with no assets to offer as collateral had to borrow from an employer at five per cent a month and repaid by working for the employer, remaining dependent for further credit even though the employer did not treat the labourer well.

These differences show that two households wanting credit for similar reasons, such as meeting living costs or financing production, can face very different costs of borrowing depending on their income, their assets and whether they can offer acceptable collateral.

What is cooperative credit?

Besides banks, the other major source of cheap credit in rural areas are the cooperative societies. Members of a cooperative pool their resources for cooperation in certain areas, and there are several types of cooperatives possible, such as farmers cooperatives, weavers cooperatives and industrial workers cooperatives.

One farmers' cooperative with 2,300 farmer-members accepts deposits from its members. With these deposits as collateral, the cooperative has obtained a large loan from a bank, and these funds are used to provide loans to members for the purchase of agricultural implements, for cultivation and agricultural trade, for fishery, for the construction of houses and for a variety of other expenses. Once these loans are repaid, another round of lending can take place.

How can households without collateral reach cheaper credit?

Some households without collateral can still reach cheaper, formal credit through a self-help group: a small group, typically of 15 to 20 members, usually belonging to one neighbourhood, who meet and save regularly, with each member saving a small amount that varies according to their ability to save.

Members can take small loans from the pooled group savings to meet their needs, charged at an interest rate that is lower than a moneylender would charge, and after a year or two of regular saving the group as a whole becomes eligible for a loan from a bank, taken in the group's name.

Because the whole group is responsible for repayment, and any case of non-repayment is followed up by the other members, banks are willing to lend to members of such groups even though individually they have no collateral; the loans are then used to meet working-capital needs, such as buying seeds or raw materials, or to acquire assets.

What is the Grameen Bank an example of?

A well-known example of lending to poor households on these principles is the Grameen Bank, which grew from a small project in the 1970s into an institution with millions of members, almost all of them women from the poorest sections of society, who proved to be reliable borrowers able to run small income-generating activities successfully.

How can a central bank widen access to credit?

A central bank can also encourage banks to lend more widely rather than only to profit-making businesses, for example by requiring periodic reports on how much is lent, to whom and at what interest rate, so that smaller borrowers are not left depending solely on expensive informal credit.

Glossary

• Household: a person or group of people living together who make joint decisions about spending, saving and borrowing.
• Disposable income: income left after direct taxes are deducted and state benefits added, available for spending or saving.
• Consumption expenditure: the amount a household spends on goods and services.
• Saving ratio: saving expressed as a percentage of income.
• Rate of interest: the percentage charged on a loan, or paid on savings, usually expressed per year.
• Confidence: how optimistic or pessimistic households feel about their future income and the state of the economy.
• Credit: an arrangement in which a lender supplies money, goods or services now in return for a promise of future repayment, usually with interest.
• Collateral: an asset pledged by a borrower as a guarantee, which a lender may sell if the loan is not repaid.
• Terms of credit: the interest rate, collateral, documentation requirements and repayment arrangement of a loan.
• Debt trap: a situation in which a borrower cannot repay a loan from income and must borrow further or sell assets.
• Precautionary saving: saving built up as a safeguard against future uncertainties such as job loss or illness.
• Durable goods: goods such as vehicles or appliances that are used repeatedly over several years, often bought on credit.
• Economic cycle: the repeated rise and fall of economic activity between periods of boom and periods of recession.

Common errors and misconceptions

• Misconception: A rise in the rate of interest always reduces household spending equally for everyone. Correct: It discourages borrowing but encourages saving; the overall effect on a particular household depends on whether it is mainly a saver or a borrower.
• Misconception: Only income determines how much a household saves. Correct: The rate of interest and the household's confidence about the future also strongly affect the decision to save or spend.
• Misconception: Poorer households borrow less than richer households. Correct: Poorer households often need to borrow just as much, or more, for everyday needs, but they rely more on expensive informal credit because they lack collateral.
• Misconception: All credit leaves a borrower worse off. Correct: Credit used to finance production or an asset that raises future income, repaid successfully, can leave a household better off; it is credit that cannot be repaid that creates a debt trap.
• Misconception: Collateral and interest rate are the only terms of a loan. Correct: The terms of credit also include documentation requirements and the method and timing of repayment.
• Misconception: Confidence only affects spending, not saving or borrowing. Correct: Falling confidence typically raises precautionary saving and reduces willingness to borrow, as well as reducing spending.
• Misconception: A household's saving and borrowing decisions stay the same throughout its life. Correct: Income, interest rates and confidence all change over a household's life and over the economic cycle, so decisions change too.

Exam-style questions with model answers

Q1. A household's monthly disposable income is $3,000. It spends $2,400 and saves the rest. Calculate the household's saving ratio. Show your working. [2 marks]

1. Saving = $3,000 − $2,400 = $600 a month.
2. Saving ratio = ($600 ÷ $3,000) × 100 = 20%.

Q2. Identify two reasons why a household with a low income may save very little. [2 marks]

1. A high proportion of its income is spent on necessities such as food and housing, leaving little over.
2. It may have to borrow to cover unexpected costs, so it has no spare income to set aside.

Q3. Explain two reasons why a rise in the rate of interest may increase saving by one household but reduce spending by another. [4 marks]

1. A household that already holds savings earns more interest income when the rate rises, so saving becomes more rewarding and it may save more.
2. A household that owes money, or borrows regularly to cover bills, must pay more interest on its loan, so it has less income left to spend.
3. The two households therefore respond in opposite directions to the same change, because one is mainly a saver and the other mainly a borrower.
4. The gap between them widens, since the saver gains interest income while the borrower loses it.

Q4. Explain two reasons why a household with an uncertain income is likely to save more than a household with a secure salary on the same income. [4 marks]

1. The household with uncertain income has no guarantee of earnings next month, so it builds up precautionary saving as a safeguard against a spell without work.
2. The household with a secure salary can rely on regular pay, so it feels less need to hold savings against bad news.
3. The uncertain household is also more likely to cut non-essential spending at the first sign of trouble, which releases more income for saving.
4. As a result, the same income can produce a higher saving ratio in the less secure household.

Q5. A household borrows $8,000 at an annual simple interest rate of 5% and repays the loan in full after three years. Calculate the total interest paid and the total amount repaid. Show your working. [4 marks]

1. Interest for one year = 5% of $8,000 = $400.
2. Interest for three years = $400 × 3 = $1,200.
3. Total amount repaid = principal + interest = $8,000 + $1,200 = $9,200.
4. The household therefore pays $1,200 more than it borrowed, which is the cost of the credit.

Q6. Analyse how a fall in confidence across an economy might affect the spending, saving and borrowing of different households. [6 marks]

1. Households that fear losing their income are likely to cut non-essential spending, such as on holidays and durable goods, because these purchases can be postponed.
2. Many households will increase precautionary saving, building a cushion against possible job loss or falling wages.
3. Households will be more reluctant to take on new borrowing, since they are less sure they could repay a loan if income fell.
4. Households with secure salaries and existing savings may change their plans very little, because they have a cushion to absorb bad news.
5. Households with uncertain income, such as casual workers or the self-employed, are likely to react most sharply, since they have least to fall back on.
6. Overall, spending and borrowing are likely to fall and saving to rise, but the size of the change will differ between households according to how secure their income is.

Q7. Discuss whether a rise in the rate of interest will always reduce household borrowing. [8 marks]

1. A rise in the rate of interest raises the cost of a loan, since more must be repaid on top of the principal, so many households will borrow less.
2. Households planning to buy durable goods such as a vehicle or furniture on credit may delay the purchase until borrowing is cheaper.
3. Households planning a house purchase may borrow a smaller amount, or wait, because the monthly repayment has risen.
4. However, some households borrow because they must, not because they choose to: a household facing an unexpected bill or a spell without income may have to borrow whatever the rate.
5. Households with a secure income and good collateral may still borrow, because they can obtain a lower rate than other borrowers and can afford the repayments.
6. A household that expects its income to rise sharply may decide that a project, such as starting a small business, is still worth financing even at a higher rate.
7. The effect also depends on confidence: if households are optimistic about the future, a modest rise in the rate may not deter them, while if confidence is low they may avoid borrowing even at a low rate.
8. Overall, a rise in the rate of interest usually reduces borrowing, but it does not reduce it for every household, because necessity, confidence and access to cheaper terms all affect the decision.

Key takeaways

• Households decide how much of their income to spend, save or borrow against; these three decisions are closely linked.
• Rising income generally increases both spending and saving, since households can meet necessities and still have income left over.
• A higher rate of interest encourages saving but discourages borrowing; a lower rate has the opposite effect.
• The terms of credit, interest rate, collateral, documentation and repayment, vary between lenders and between households.
• Rising confidence encourages spending and borrowing and reduces precautionary saving; falling confidence has the opposite effect.
• Lower-income households spend most of their income on necessities and save little; higher-income households save a larger proportion.
• Borrowing that cannot be repaid from income can push a household into a debt trap, forcing further borrowing or asset sales.
• Spending, saving and borrowing patterns change over a household's life and over the economic cycle, as income, interest rates and confidence change.

Test yourself

What is disposable income?

Disposable income is the income a household has left to spend or save after direct taxes are deducted and any state benefits are added.

How does a rise in the rate of interest affect a saver and a borrower differently?

A saver earns more on money saved, so is encouraged to save more; a borrower must repay more, so is discouraged from borrowing.

Why might a lower-income household save less than a higher-income household?

A lower-income household spends a high proportion of its income on necessities, leaving little or nothing over, while a higher-income household covers necessities easily and can save more.

What is a debt trap?

A debt trap is a situation in which a borrower cannot repay a loan from income and must borrow further or sell assets, leaving them worse off.

How does falling confidence usually affect household saving?

Falling confidence usually raises precautionary saving, as households try to build a safeguard against an uncertain future income.

Why might two households on the same income save different proportions of it?

Their essential outgoings differ, for example because of the number of children, and their expectations of future income differ, so one may need a larger cushion than the other.

Why might household borrowing fall during a recession even if interest rates are cut?

Falling confidence about future income can make households reluctant to borrow even when borrowing is cheap, because they are unsure they could repay the loan.

How does income over a household's life typically affect its saving?

Saving tends to build up during working years as income rises, and is often drawn down later, for example in retirement, when income falls.