Impact Of Interest Rates On Household Decision Making In The UK

Factors Affecting Household Decision Making

Discuss about the Paradox of Household Decision Making.

Consumer often reacts and takes impulsive decision in their daily life. Survey suggests that they often take irrational decision while making a choice of their consumption behavior. Households often think that they are risk taker in their decisions (Himmelweit et al. 2013). On other hand, people are expected to act rationally and invest on fixed assets like purchasing a house which can in future generate further utility. Consumers are also expected to invest on equity and take up their liabilities of household mortgages and loans.

There are several factors that collectively dominate the complex micro-financial decision of any consumer. Few of them are: the rate of interest as offered by the banks of that nation, their capacity to invest after meeting up the expenditure of their daily chores and the existing rate of inflation on the economy (Diamond and Rothschild 2014).

The essay focuses on the impact of such factors on the decisions taken by the dwellers of U.K region. After the nation existed from their alliance from Brexit, it has faced a continuously downfall in their interest rate. A single component in turn dampens the entire economic condition by impacting the immediate savings, future scope of investment. This essay also focuses on the life cycle hypothesis to analyze the uncertainty principles, especially the weak uncertainty and the strong uncertainty that drives a rational consumer into their decision process (Hanushek et al. 2016).

This essay initially focuses on the basic problem that persists in the economy. Then the essay briefly explains the concept of weak and strong uncertainty that the people exhibits through their behavior. People’s balance between the risk taken and their choice for a secured future portrays the rationality that they are imbibed with (Belke et a. 2016). U.K has been chosen and the country’s overall behavior has been highlighted keeping in mind their recent exit from the European Union. The basic economic theory has evolved with incomplete information and uncertainty involved in investment. Here the profit maximization theory is dispensed and the theory rejects the predictable individual behavior. The approach incorporates the societal evolution and the economic system with adoptive mechanism. Situation where the fore sight is uncertain the profit maximizing option is invalid. After the Brexit, the whole economy in the European Union has undergone a change. In this change in the economic environment, individual’s behavior is motivated by the prevalent uncertainty and incomplete information (Fichtner et al. 2016). Behavioral traits like imitative, trial and error behavior and adaptive behavior are observed among the individuals.

Behavioral Traits and Economic Decision Making

The Rational Choice Theory is a framework to understand the formal setting of the social and economic behavior. The basic argument of the theory is based on the aggregate behavior of the society. The aggregate behavior results from the behavior of the individual actors. It mainly focuses on the determinants that influence the behavior of the individual (Jaeger et al. 2013). The individual chooses from the available options. The individual in the household makes his choice depending upon the available information and the possibility of information. The individual decision inclined toward the cost-effective possibility.

Let us assume that the consumer have a life span over T years and has W amount of wealth. His annual income is Y. let us assume that he retires at the age R. the initial wealth is W and his lifetime earnings is RY. Thus, he divides his entire wealth that is W+RY over his entire lifetime. Hence, his consumption C = (W+RY)T.= (1/T)W + (R/T)Y= a(W/Y) + b. this equation denotes the average propensity to consume. Wealth does not change proportionately with income from year to year. So the expected result should be that high income results in low propensity to consume (Dow 2014). However, in the long run both wealth and income increases simultaneously which leads to a constant ratio W/Y implying constant average propensity to consume.

max ∫ u(az + (w-a) r) dF(z). a

Now, the change in wealth changes with the individual’s preference toward the risk. It is assumed that two individual are having identical wealth in their savings account, but one is having H amount of money extra in his account. Thus, both the individual is ready to take a risky gamble. This behavioral trait is captured in decreasing absolute risk aversion (Frank 2013). And the individual decides to invest his wealth W. He has two choices: i) safe with return r  ii) risky asset with random return z. the utility function of the individual is a concave utility function denoted u. He buys an amount of the risky asset. If, he chooses the risky asset and invest the remaining W-a in the safe asset, then the utility function will be given by az+ (W-a) r. the optimizing problem is given,  

∫ u’(a(z-r) + wr) (z-r) dF(z) = 0.

Now the first order condition for this problem is given by: 

Here, the person is risk-neutral, so u(x) = ax for a constant α, the marginal return in investment is

αWr + αa(Ε(z)-r) which is either positive or negative. The risk-neutral investor cares only about the expected return on his investment. Hence, he puts his wealth into the asset, which has a higher expected return. If the investor has a positive rate of return that is greater than r, a risk adverse investor will still invest at least some amount the asset with risky return. Thus, in the example of interest rate this argument is applicable (Frank 2013). If the rate of interest increases, a risk adverse individual will tend to invest more in that asset. On the other hand, a risk neutral individual will optimally allocate his asset between the risky asset and the risk free asset to maximize his return on his investment.

Rational Choice Theory and Household Decision Making

The essay tries to see the effect of the basic changes in the economy of United Kingdom due to the change in factor of interest rate of the country as guided by their Central Bank (Kierzenkowski et al. 2016).  Also people often have the notion of consuming more when they do not get sufficient interest from their spending. They are more reluctant to believe and act as accordingly to the situations that they presently sees. They cannot interpret the amount that they need to save for the future as the future always remains unseen. The government of the United Kingdom has been reducing the country’s rate of interest for a few years in a row. The reason behind this is to increase the level of investment in the country. This will in turn increase the aggregate demand in the country. The interest rate has been reduced by the Bank of England after the country exited from the European Union (Kierzenkowski 2016). The Foreign Domestic Investment in the country has been reduced since the Brexit. The reduction in interest rate is supposed to increase the consumption and reduce savings presently in the short run. In the long run, the macroeconomic variable changes. This will make taking a decision hard for the households. People choose their retirement packages and savings according to their working age and old age. The trend of low interest rate has been ensured by the authorities to increase the inflation rate. The interest rate in the country for the last ten years can be depicted in a graph as given below:

Figure 1: Interest rate in the United Kingdom for the last ten years.

Source: As created by the author.

The people of the country are supposed to take their decision on consumption based on the assets and liabilities. The households take their decisions according to their income and the rate of interest in the country. The interest rate determines the value of their assets and liabilities. The government has taken the monetary expansionary policy assuming that the households will make a rational decision. As the claim done by Merton, people are not trained for making these kinds of decisions. People of the United Kingdom have the task ahead of disaggregating their life cycle economic decisions and act accordingly (Lee 2016). They have to make micro financial decisions which involve risk. They have to allocate their asset and estimate the optimal level of utility they can derive. The main target remains as increasing the total savings in such a way that the life after retirement goes smoothly. The decision taken by the government of reducing the interest rate will reduce the size of the retirement package for the working people in the country. This presents a situation of uncertainty in the economy. The uncertainty and risks are interrelated hugely. The rational households are assumed to show a positive attitude towards risk taking and show responsible behavior through financial actions.

Effect of Interest Rates on Household Decision Making

The life cycle hypothesis proposes that an individual’s consumption and savings are planned over his entire life cycle. Their intention is to even out the consumption over his entire life cycle in the best possible way. He prefers to accumulate and save when he is earning. In his retirement age he is dis-saving. The life-cycle hypothesis is based on the assumption that individual is trying to maintain a stable living standard (Hanushek et al. 2016).. This does not imply that he saves a lot in one period and spends all his savings in the next period. They tries to maintain an even consumption level throughout their life span.

To understand the situation in the economy of the United Kingdom the life cycle hypothesis can be considered which will give the paradoxical behavior of the households a theoretical shape. Risk and uncertainty will also be incorporated in the report to assess the behavior. The people of the United Kingdom have the task ahead of disaggregating their total life span decisions into small parts (Shoemaker 2016). Their total possible income has to be divided in these parts for consumption purposes. Some of the parts will fall in the working age and some will not. These can be incorporated in two categories where an individual is working and when he is not or retired. The savings from his working age added with the interest he gained from saving will be his total expendable income for his retired life. In such a situation the interest rate, mortgage rate and other policies taken by the government creates uncertain situations. If the interest rate falls further the amount of money the person was supposed to get after retirement will decrease (Jaeger et al. 2013). Hence the person has to understand the present and future risks involved in an investment. The questions the individual has to ask himself before making an investment are: whether the growth in the stock market will be a steady one? The real estate will show a boom in the future? Is there any chance of the government of the United Kingdom to default on its debt? The decisions should make sense with the economic rationality which will consider the risk, weak and strong uncertainty regarding the decision of investment. To make a well informed decision regarding future, the individuals have to know all these theories and act accordingly. Merton argued that common people in the United Kingdom do not have the required training of doing so.

Conclusion

Conclusion:

The general people are unaware of the complexities that are involved in an economic system. They make their decisions on the basis of the situations that they see in their daily life. Most of them are unaware of the complexities involved in their decision process. They always try to maximize their consumption and also save for their future. They are expected to take risk in their investment decision by spending their hard earned money on buying fixed assets whereas save for the future so that they can have a secured life in their autumns of life (Himmelweit 2013). Whenever people get more interest rate they start to save more with the expectation of higher amount of interest. On other hand they start more consumption as a result of lowering interest rate. But at the same time saving less will reduce the scope of their future consumption. The government can spread financial awareness amongst the people. Also an extra curriculum can be added at the high school level so that the students irrespective of the stream of subjects that they undertake can learn the very basics of financial components and take a rational decision in their life ahead. A successful implementation of this curriculum and an overall financial awareness campaign may prove efficient in removing the paradox that exists in the economy.

References:  

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Frank, K., 2013. Risk, uncertainty and profit.

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Himmelweit, S., Santos, C., Sevilla, A. and Sofer, C., 2013. Sharing of resources within the family and the economics of household decision making. Journal of Marriage and Family, 75(3), pp.625-639.

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Kierzenkowski, R., Pain, N., Rusticelli, E. and Zwart, S., 2016. The Economic Consequences of Brexit

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