Saving and Interest Rates

Savingand Interest Rates

Savingand Interest Rates

Accordingto economists, interest rates have a positive relationship with netsavings. This means that an increase in interest rates makes savingsmore attractive as they would receive higher interest payments.Similarly, a cut in the rate of interest decreases the rewards ofsaving making them unattractive. This scenario affects the consumer’schoice on the proportion of income delegated to savings and spending.Consumers who choose to spend more of their income end up saving lessand vice versa[ CITATION Man l 2057 ].However, in the real world, this concept is more complicated as thereare many factors that affect savings such as advertising, confidencein financial institutions, the size of disposable income, inflationrates and precautionary factors. The majority of saving accounts areliquid accounts meaning they protect the principal value depositedwith the bank while Consumers on the other hand value the safety andflexibility of bank accounts. When banks want to receive extradeposits, they raise the interest rate on deposits to attract extracash and lower them when they want to decrease bank debits. It shouldbe noted however that banks do not offer higher interests on savingsthan the rates charged on loans or income earned from alternativeinvestment[ CITATION GYl81 l 2057 ].

Ina bid to conceptualize their thinking on what affects saving,economists developed models that mainly focus on people’s spendingbehaviour. The framework used sees people as life-cycle or long runplanners who take into consideration current economic conditions andanticipated future conditions when budgeting or making theirfinancial decisions. It views people as having the freedom to lendmoney that has the implication of people not being constrained totheir income when spending preferring a smooth consumption patternover their lifetime. It was identified that the rate of return onbank deposits was significant in the saving-spending decision as itinfluenced their proportion of wealth consumed currently and theamount of the individual’s lifetime wealth. Theoretically, changein interest rates affects the fraction of the wealth that is used incurrent spending in two ways: first, tweaking with the financialattractiveness of saving and spending[ CITATION Car82 l 2057 ].A consumer will easily fore go current expenditure if they areguaranteed it will yield a reward that takes the form of greaterconsumption at a futuredate. The second factor that influences people`s decision to save isaccumulating funds to meet payments that would potentially put astrain on their current income. In this case, the slightest return ondeposits regardless of how low it is will create an initiative tosave more. A couple of researchers have utilised statistical measuresin a bid to measure the relationship between interest rates andsavings in households especially by the use life cycle models toexplain a person’s spending behaviour over their lifetime[ CITATION Bli75 l 2057 ].

Statisticsshows that Canadians spent more by the close of the 20thcentury compared to the 1980`s. This was mainly attributed to the tworecessions witnessed during this period and the inability of incomegrowth to keep pace with the average expenditure by households thatrose by 10% while expenditure on recreation rose by 40%[ CITATION Kre02 l 2057 ].Due to economies of scale: benefits accrued for selling at a largescale, companies dealing with recreation goods produced higherquality goods at cheaper prices increasing the level of demand in themarket. This means that more money was being used on currentexpenditure and less available for deposit into bank accounts. Asseen in Table 1, `the rate of savings by households went downsignificantly around this period. In response to this trend, banksraised their interest rates to encourage people to save so that theycould channel these finances to borrowers who pay back with intereston loans.

Thereis sufficient evidence to show that the spending habits of Canadianschanged over time as a result of the recession and increasedexpenditure in both household and recreation goods. This had theeffect of reducing the proportion of disposable income allocated tosavings. Economic forces adjust to this change by increasing interestrates so as to encourage more savings into bank saving accounts.Hence, the commentators were right to blame spending habits of theCanadian public for high-interest rates.

References

Blinder, A. (1975). Distribution effects and the Aggregate demand function. Journal of political economy, 447-475.

Carlino, G. (1982). Interest rates effects and Intertemporal consumption. Journal of monetary economics.

GYlfason, T. (1981). Interest rates, Inflation and the Aggregate Consumption Function. The Review of Economics and Statistics, 223-245.

Kremarik, F. (2002). The changing recreational spending patterns of Canadian families. Canadian Social Trends, 13-18.

Mankiw, K. a. (n.d.). Principles of Macroeconomics, 6th Canadian Edition, Chapter 8.