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What’s it: The household sector includes individuals or groups of individuals. A household may consist of one or several people who live in the same household and share food. They may include one family or another group of people.
On the one hand, households become consumers of goods and services produced by the business sector. Their consumption is a major determinant in stimulating economic growth in several countries, and their spending accounts for most of the gross domestic product (GDP).
On the other hand, they provide inputs to the business sector in exchange for wages, interest, and profits. They provide factors such as entrepreneurship and labor. For example, they become entrepreneurs and unite the other three factors of production (land, labor, and capital). As owners, they have a claim to the business and earn profits as compensation.
The household sector’s multifaceted roles
Depending on the market, the household sector acts as a supplier and a consumer. Let us discuss its contribution to factors, products, and financial markets.
Supplying inputs to business
Households supply inputs to the business sector in factor markets. They provide labor as an input in the production process. They may work as blue-collar workers and do manual work like in a factory. Or, they work as white-collar workers to do professional, managerial, or administrative work. They receive salaries, wages, and other benefits such as insurance and pensions.
In addition, households also supply entrepreneurship. They act as entrepreneurs. They take risks by uniting other inputs (capital, labor, and land) to produce goods and services. In return, they make a profit.
Consumers for goods and services
Households act as consumers in the product market. They buy goods and services from the business sector using the money of their supply inputs. The money they spend flows into the business sector as income.
As consumers, households play a strategic role in driving the economy. Their money contributes significantly to aggregate demand (measured by GDP), usually exceeding spending by the business, government, and external sectors.
Thus, when households spend more money on goods and services, the economy can grow at a higher rate. In addition, their spending encourages businesses to increase production and recruit more workers. Eventually, it leads to an increase in output and a decrease in the unemployment rate in the economy.
Source for financial capital
Households supply financial capital to the business sector. They set aside their income as savings. For example, they invest in financial instruments such as bonds issued by the business and government sectors. In return, they receive income such as coupons and capital gains.
Meanwhile, companies use funds from bond issuance to buy capital assets or open new factories. Meanwhile, the government may use it to build infrastructure.
Households can also save their money in the bank. In return, they earn interest. Savings in the bank also contribute to financial capital. For example, banks channel household savings to real sectors such as manufacturing.
Meanwhile, some households may invest in real assets such as property, which provides them with rental income. Say, they rent a shophouse to tenants to open a retail business.
Financial and real assets above represent household wealth, an important factor influencing consumption and income. For example, when their assets appreciate, they become richer and are willing to spend more money on goods and services. Finally, it stimulates the economy to grow. We call how the increase in the value of their assets impacts economic growth the “wealth effect.”
Paying taxes
Households also act as taxpayers to the government. The taxes they pay become revenue for the government, which uses it for capital expenditures, routine expenditures, and transfer payments such as unemployment benefits.
Households earn income from supplying inputs to the business sector. In addition, they also get income from government transfer payments. And they do not spend all their income on goods and services. Rather, they have to pay taxes first – the total income minus the tax is known as disposable income.
Disposable income is available for consumption and savings. As I explained above, households save their income in financial markets by buying financial assets such as bonds. Meanwhile, they spend the remaining dollars on goods and services.
Back to taxes. Households pay taxes directly to the government. Examples are individual income tax and capital gains tax. Or, they pay indirectly, such as value added tax, levying on the goods and services they consume.
The household sector and the circular flow model
Economists use the circular flow model to describe how the household sector relates to other sectors, such as business and government. They present it in a diagram, which shows us how output, income, and inputs flow between the sectors, as I described above.
Let’s take a three-sector economic model: households, businesses, and government. The interactions between households and businesses occur in factor, financial, and product markets. In product markets, households buy goods and services provided by businesses. Businesses earn money as income and then use it to buy inputs provided by households in factor markets.
In factor markets, households supply inputs to businesses to produce goods and services. In this market, businesses act as buyers, while households act as suppliers.
Then, households also earn income from providing labor inputs and transfer payments. Likewise, businesses can also earn income by selling goods and services to the government. And both sectors pay taxes to the government.
Lastly, households, businesses, and governments interact in the financial market apart from interacting in the factor and product markets. For example, households buy debt securities issued by businesses and governments. As a return, they earn income such as coupons and capital gains.
Household income and expenditures
Households earn income through various channels. This income comes from:
- Wages and salaries: Compensation received for labor provided to businesses.
- Entrepreneurial income: Profits earned by individuals who own and operate businesses.
- Government transfers: Payments received from the government, such as unemployment benefits or social security benefits.
Not all income earned is freely available for spending. Households must first pay taxes to the government. These taxes can be direct, such as income tax, or indirect, like sales tax added to purchases. The remaining income after taxes is called disposable income.
Disposable income represents the money households have available for spending on goods and services or saving for future needs. This spending decision plays a crucial role in the economy. Higher household spending translates to increased demand for goods and services, which incentivizes businesses to produce more. This increased production can lead to economic growth and job creation.
However, households don’t always spend all their disposable income. Some choose to save a portion of their income for various reasons, such as retirement planning, future investments, or unexpected expenses. These savings can be deposited in banks, invested in financial markets (bonds, stocks), or used to purchase real estate.
The balance between household spending and saving decisions ultimately affects aggregate demand and economic activity. Here’s how:
- Increased spending: When households feel confident about the future and have a healthy level of disposable income, they are more likely to spend more. This increased demand for goods and services encourages businesses to expand production, hire more workers, and invest in new equipment. This cycle leads to economic growth and a decrease in unemployment.
- Increased saving: While saving is crucial for individual financial security, high saving rates across a large portion of the population can dampen economic activity. If households prioritize saving a significant portion of their income, businesses may face lower demand for their products. This can lead to slower economic growth or even recession if businesses are forced to cut production or lay off workers.
Governments and central banks closely monitor household spending and saving habits to gauge consumer confidence and overall economic health. By implementing policies that incentivize spending or saving, they can attempt to influence aggregate demand and steer the economy towards a desired outcome.
Household debt
Households can access additional funds beyond their current income through borrowing. This creates household debt, which refers to the total amount of money owed by individuals or families to lenders. Common forms of household debt include:
- Mortgages: Loans used to finance the purchase of a home.
- Student loans: Loans used to finance higher education.
- Auto loans: Loans used to finance the purchase of a vehicle.
- Credit card debt: Revolving credit line used for various purchases.
Household debt can be a powerful tool for individuals and families to achieve financial goals like homeownership or higher education. However, excessive debt can burden households, leading to financial strain and impacting their ability to spend on other goods and services.
Impact on spending: High levels of household debt can lead to decreased consumer spending. When a significant portion of income is dedicated to debt repayment, less disposable income is available for other purchases. This can dampen economic activity as businesses experience lower demand for their products.
Impact on economic vulnerability: In economic downturns, households with high debt may struggle to make repayments. This can lead to defaults, foreclosures, and financial instability, potentially triggering a broader economic crisis.
