How income and interest rates affect spending, saving and borrowing

G3 Economics - syllabus K343, 2027

What this lesson teaches

  • I can explain how income, interest rates, confidence, age and culture affect household spending, saving and borrowing.

    Syllabus K343, 3.2.1. Influences on households' spending, saving and borrowing: income; rate of interest; confidence; age; culture

Make a guess

Interest rates rise sharply. What does a family planning to buy a car on a loan most likely do?

  1. Delay the purchase, because the loan now costs more.
  2. Buy sooner, before the price of cars goes up.
  3. Buy as planned, because the price of the car is the same.
Show the answer

Delay the purchase, because the loan now costs more.

A higher interest rate makes borrowing dearer and saving more rewarding, so households borrow and spend less.

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%.

  1. Savers: $10,000 in the bank now earns $400 a year instead of $200, so saving becomes more attractive.
  2. Borrowers: a car loan becomes dearer, so some families delay buying a car.
  3. Existing borrowers with variable-rate home loans pay more each month, leaving less to spend.
  4. 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

A family's income goes up by 20%. What is most likely to happen to how much it spends and saves?

  1. Spending rises, but saving falls so the family can fund it
  2. Both rise, as the family can afford to do more of each
  3. Saving rises, but spending stays at the level it was before
Show the answer

Both rise, as the family can afford to do more of each

Right. Higher income lets households spend more and save more at the same time.

Check your understanding

A household's disposable income is $5,000 a month and it spends $4,200. What percentage of its income does it save?

  1. 84%
  2. 8%
  3. 19%
  4. 16%
Show the answer

16%

Right. Saving is $5,000 - $4,200 = $800, and $800 / $5,000 x 100 = 16%.

Check your understanding

Monthly pay goes from $4,000 to $5,000, and monthly spending goes from $3,600 to $4,200. What fraction of the pay rise is put aside?

  1. 10%
  2. 40%
  3. 16%
  4. 60%
Show the answer

40%

Right. Extra income is $1,000 and extra spending $600, so $400 of the extra $1,000 is saved.

The Wise Otter

Getting your study space ready