Household Dynamics

Household Dynamics

Households provide cooperative arrangements for members and nurture them and look after them thus contributing to their welfare. Households also lead to development of values and healthy behaviour. Households help their members to be part of a healthy society. As society develops and education, health, and non-discriminatory treatments of individuals increase, more value is created and social welfare increases. Households enable members to develop their capabilities, join in social value creation through employment, work and different kinds of contracts in different kinds of institutions and enable their members to adjust to changing circumstances. Over time, household objectives, size and composition, different internal rules and constraints, the structure of incentives of individual members change as social and economic structure develops and changes.

Lifetime Utility Improvement

An individual enjoys satisfaction or utility from consumption and work (though the work effort also creates disutility) as per his or her preferences. A household helps in lifetime utility improvement for an individual member. An individual goes through childhood, youth, middle age and old age and requires utility differently in each phase of his or her own life.

During childhood the individual needs protection from the elders and the community, health improvements and improving life expectancy, positive psychology and motivation, opportunities to play games with peer groups and being coached in different games, education and development of knowledge, capabilities and skills, healthy values, social interaction leading to increased awareness of the environment and expectations and aspirations regarding the development of his or her own life.

During youth, the individual completes higher education and embarks on a career. The individual begins to learn not only from education but also from various events, constraints and opportunities that he or she begins to face life. He or she may get married and have children. They may be part of the bigger family living together or may decide to or may be forced to live as a nuclear family while keeping different connections with other household members. The young individual household member may be looking after the children, the elderly and other young and middle age members. Responsibilities increase and the individual becomes aware of these and various other constraints and obtains various forms of guidance from superiors in work, peer groups, siblings and married partner. The economic, social and political of the young member increases and allows him or her various choices. He or she tries to develop the family as per the preferences, opportunities and constraints. In work, the household member tries to generate productivity and sufficient income so that he or she may spend adequately and save prudently for the family. Increasing income and influence over decision making in work become important, social networks become important and ability to look after and develop the family become the fundamental concern of course. A good balancing of work and leisure activities yields utility and leisure may take various forms like reading good books, enjoying movies, theatres and operas, taking holidays and visiting various interesting places, mountaineering or skiing, playing various games etc. As middle age gradually approaches, the young member tries to consolidate his or her career, social ties, wealth and savings, improved consumption patter etc.

In middle age, the household member becomes a leading decision maker at work, family and in social institutions of various kinds of which he or she may be sharing membership. With more responsibility and greater demands for various kinds of decision making, the individual faces a lot of pressure with little time available to balance various needs. Expectations become increased and one has to cope with increased expectations imposed on him or her. Savings from income become a very important part of the financial life of the household member. He or she not only has to decide how much to save from earnings but also how to allocate the savings in the form of cash, bank deposits, mutual funds, stocks and bonds, insurance, pension contribution etc.

During old age, the household member has retired from work unless he or she is a professional or a business entrepreneur. He or she begins to draw down from the lifetime savings in a gradual manner. As and when he or she needs health care, there is social security benefits and his own savings apart from subsidized health programmes. He or she takes more holidays depending upon life time income and spends on housing and consumer durables apart from standard consumption.

In each period of any life cycle phase, the household member faces a basic tradeoff: increased savings and work effort may reduce immediate utility but enhances later utility. The equilibrium is attained at the margin where immediate utility loss is equal to discounted future utility gain through a higher return from savings and current work effort. Within lifecycle phases, such equilibria are almost automatically attained. However, between different phases, the choices yield equilibrium only when the household member is farsighted and undisturbed by large external changes. Otherwise, there are deficiencies which could be improved upon by better life cycle planning and management.????

Lifecycle Budget Constraint

The lifecycle budget constraint integrates the short period (usually annual) budget constraints. The short period budget constraint imposes the condition that value of consumption plus the value of interest payments on previous borrowing (if any) plus the value of the savings portfolio chosen is less than or equal to current income plus the accumulated wealth plus current borrowing. When integrated, these yield the following: the sum of discounted values of consumption over the lifecycle is the sum of the discounted values of income minus the wealth passed onto the future generations (intended or unintended) through bequests and gifts plus value of borrowing unpaid (wilful default or unintentional due to events like personal bankruptcy or death).

Unless childhood is partly spent in working (child labour), the experience of short period budget constraints and the life cycle budget constraint really begins in youth. There may be education loans which might be obtained by pledging future incomes. There may be loans for purchasing consumer durables and to finance the acquisition of real property and financial assets. Typically, the needs are greater than the income level for the young household member and he or she may be forced to borrow or dissave. As incomes rise, the young repays the loans gradually and may begin to save after some point of time.

The middle age experiences a consolidation of income gains and adjustment of spending habits to incomes and probable future wealth. Previous borrowing is repaid as fast as can and there is a conscious effort to enhancing the value of portfolio of financial assets held and other liquid property. Some risks are taken in the form of stocks and mutual funds, to be balanced by bank deposits and bonds and some health and life insurance. Dynamic trading of some financial assets are also contemplated and achieved depending on various factors. All these lead to significant wealth and welfare gains in old age.??

Savings and Asset Accumulation

Over time, working and saving by individual members lead to asset accumulation by households. Initially the household might be enjoying property as an owner or tenant. As income and savings increases and borrowing capacity increases based on future income generation possibilities, more of property can be enjoyed through ownership and accumulation of different kinds of property like housing, apartments, land, consumer durables like radio, television, refrigerator, washing machines, heater, cooking oven, bicycles, cars, computers, mobile etc. Asset accumulation thus increases individual utility and increases social welfare. The households also accumulate financial assets which represent precautionary savings and savings for retirement, bequests and gifts. The financial assets consist of cash in hand, bank deposits, insurance policies, stocks and bonds, postal savings deposits, mutual funds and contribution to pension funds and employee provident funds. When income is low, assets are held as land and cash but as income increases, other types of financial assets come into portfolios. As income increases, savings and household asset accumulation increases, thus more can be available for investment in industry and finance which can lead to further rise in incomes, contracts and employment thus contributing further to savings and household asset accumulation. This is an extremely virtuous cycle for the economy leading to higher income, wealth and greater consumption thus creating more utility and social welfare as a whole. However, how this cycle begins, gets strengthened and sustained and leads to other kinds of virtuous cycles need to be carefully examined. An economy can stagnate, provide low benefits for the majority and can go through structural change and business cycles. Thus social welfare may be affected through these constraints on household asset accumulation.

Consumption

Households not only save and accumulate but also consume from their incomes and wealth. Basic necessities have to be consumed in the form of food, clothing and shelter. With a low income level the household struggles to access the basic necessities and can hardly save. This goes against welfare not only in the sense of low individual utility but also low savings induced low capital accumulation and low incomes which create inadequate social welfare. As incomes rise and household members aspire to consume what the affluent individuals in society enjoy, consumption rises. More nutritious food is demanded, variety is demanded in food, clothing and shelter and conspicuous consumption in the form of holding various assets and consuming various items which lead to increase in perceived status begin to dominate. Overall, as income rises for a household member, both consumption and savings increase and depend on the way an individual looks at consumption, discounts future utility from consumption and the way an individual has an aversion to risk and the love of reward from saved assets. Just as savings is beneficial for economic progress, consumption is also beneficial for income generation, employment creation and investment. Greater consumption increases demand and provides profitable opportunities for firms and industries to employ and invest and grow thereby raising income and generating further consumption. This can also be a virtuous cycle in creating affluence and greater social welfare. In what proportion a society should save and in what proportion it should consume is an extremely important issue since there are tradeoffs because high savings may lead to lower demand and high consumption may hurt savings induced investment and income expansion. This will be discussed in the different contexts of economic dynamics.

Occupation Choice and Income

Now I turn to other aspects of household dynamics. A household member, in order to earn income and ensure consumption and savings, has to find a suitable income earning opportunity and try to develop earnings expansion over his or her working life. As in agriculture, retail or wholesale trade, law, medicine, management or finance an individual may simply take up the career which his father or mother had. But with structural changes in the economy and new sectors replacing old sectors in influence and profitability, the individual matches his or her education, skills and talents, aspirations to the demand for the services he or she may offer and choose a career quite different from his parents. Further, women in particular may increasingly join the labour force and develop aspirations and demand a satisfying career similar to men with the nuclear small family becoming the norm. Education thus become more important as the society develops and new career paths are generated. There is hierarchy in any career or industry and climbing up the hierarchy becomes necessary in order to increase earnings, influence, power and overall satisfaction in a job. The diligent and patient worker is thus demanded. Educated and industrious workers working in an industrial hierarchy increase productivity and profitability in the firm and the industry and contribute directly or indirectly to increasing social welfare. Some individuals may have entrepreneurship qualities and when combined with their talents, education and business opportunities, they may create and become founders of business in trade, industry and finance. They make industries grow and add to national wealth and contribute to economic system dynamics in different ways. Individuals learn from working in an organization and through information exchanged with friends and social networks besides information generated in the household. With learning, their attitudes to work, savings and consumption change and their risk perceptions change. They may become more cautious and increase precautionary savings and become conservative in health habits, work strategies and social interactions. They may become more industrious and entrepreneurial and switch jobs and start business organizations on their own or through partnerships. They gain in influence and may become instrumental directly or indirectly in creation of corporate organizations. Individuals may learn to create better financial portfolios through experience and learning and monetary, savings and investment growth paths may change as a result. Through their experience and learning, individual household members contribute to economic change and dynamism and to social welfare in diverse ways. Household members may become local community oriented and contribute to local activity in education and health care. They may become more environmentally conscious and more sensitive to local and national politics. These lead to social organizations and polity becoming more incentive and information oriented and create opportunities for broad based changes in social welfare.

Household Finance

An economic agent (whether a worker, entrepreneur or a financial intermediary manager)? has to choose a savings rule which is rational and subject to maximum intertemporal smoothing and determined by an expectation formation rule which is reasonable. I postulate that expectation of future wage income and income from risky assets is essentially such that the historical trend is constructed after removing the cyclical component from past income observations and the future trend is constructed by linking a few data points which are “almost certain” future income observations at different future dates. At any date, the average of predictions from historical trend and future trend is taken as a way of forming expectations but as one of the “almost certain” event approaches, then future trend determines expectations of current and near future incomes. Given this assumption about expectations I now come to the “savings rule”. The member tries to save a constant fraction of expected lifetime income (see Modigliani (1986)) such that the present value of such consumption stream equals the present value of his expected income stream subject to some minimum precautionary savings in a safe asset to counter uncertain and urgent liquidity needs, to counter transaction costs and to counter income uncertainty (unemployment risk, variable income profiles of risky financial assets) and also subject to income and borrowing constraints. At each date, some household members save part of their income as safe financial assets like bank deposits and risky financial assets stocks, bonds respectively and real assets (like real estate) depending on his liquidity-risk-reward preference. Other household members, particularly the unemployed and the potentially rich members in the future, dissave and borrow from banks to finance their consumption and investment activity (financial assets, real estate, gold etc). At each date, household members reallocate their wealth through changing the portfolio of the assets they hold. I assume that earning members contribute to unemployment insurance, health insurance and social security and receive benefits contingently.