Higher income raises spending and saving; higher interest rates encourage saving and discourage borrowing.
Households use their income in two ways: they spend it or save it. Saving is income not spent. Borrowing lets a household spend more than its income now, but the loan must be repaid with interest.
Income: when income rises, households usually spend more. They also tend to save a larger share of it. A low-income household must spend most of its income on necessities, so it saves little. A high-income household can save a bigger proportion.
Interest rate: a higher interest rate rewards saving, so households save more. It also makes borrowing dearer, so they borrow and spend less, especially on big items bought with loans such as cars and homes.
A lower interest rate does the opposite: saving is less rewarding and borrowing is cheaper, so spending tends to rise.
- Saving
- Income not spent.
- Income effect
- Higher income raises spending and the proportion saved.
- Interest rate effect
- Higher rates raise saving and reduce borrowing and spending.
Worked example: An interest rate rise
Suppose interest rates rise from 2% to 4%.
- Savers: $10,000 in the bank now earns $400 a year instead of $200, so saving becomes more attractive.
- Borrowers: a car loan becomes dearer, so some families delay buying a car.
- Existing borrowers with variable-rate home loans pay more each month, leaving less to spend.
- Overall: household saving tends to rise, and borrowing and spending tend to fall.
Watch out for this
When income rises, households only spend more and never save more.
Higher income usually raises both spending and saving. Richer households tend to save a larger proportion of their income.
Check your understanding
Interest rates fall sharply. What is the most likely effect on households?
- Borrowing becomes cheaper, so borrowing and spending rise.
- Saving rises because interest is lower.
- Spending falls because loans are more expensive.