Households dispose of their post-tax income by spending or saving. Saving is a withdrawal from the circular flow of income and it has a pivotal role in determining changes in national income over time.
In general, saving is a positive function of income – the greater the income the greater the likelihood of saving.
Expectations about the state of the economy affect household decisions to save and spend. In general, positive expectations would tend to reduce savings and increase spending whereas negative expectations would increase savings and reduce spending.
Fear of unemployment will act in the same way as negative expectations, making saving more likely and spending less likely.
Given that interest rates provide a reward to saving, a rise in interest rates will provide an incentive to save. However, when mortgage rates rise, homeowners may be forced to increase their monthly repayments, and this leaves less income available for saving.
Changes in asset prices, such as houses and shares, can affect confidence and generate wealth effects. In response, households may change their savings. For example, a rise in house prices would tend to encourage spending and discourage saving because higher house prices lead to positive equity for homeowners, and less need to save for the future.
Finally, saving may be encouraged by the availability of tax efficient savings schemes, such as the UK’s ISAs (Individual Savings Accounts).
The household savings ratio shows the proportion of household income that is saved. In the UK, the savings ratio varies between 12% and 4% and is fairly volatile from year to year.
If the savings ratio is too high, there may be insufficient spending in the economy. This will be beneficial if the economy is growing too quickly, but is problematic if the economy is growing slowly, or is in recession.
A low savings ratio means that consumer spending may be too high and there may be insufficient funds for investment. In the short run, low savings will increase standards of living, but in the long run a low savings ratio will mean that fewer funds are available for investment, and economic growth may suffer.
Sudden changes in the savings ratio are an indicator of future changes in spending and AD, and can be a prelude to inflation, or deflation.
A rise in the savings ratio indicates a fall in consumer confidence, whereas a fall in the savings ratio indicates a rise in confidence and spending, which can trigger a rise in the price level.
Between 2004 and 2005 the UK savings ratio rose from 6.1% to 7.3%, then fell to an historic low of 4.5% in the first quarter of 2008. By the last quarter of 2008 it rose to 7.1% as households became increasingly concerned at the impending recession. Since then, the trend has been upwards, reflecting general uncertainty about growth and jobs. It peaked at 11.9% in the third quarter of 2010. By the second quarter of 2015 the savings ratio had fallen back to under 5%, reflecting increasing consumer confidence.