An unexpected expense, a decline in income or a period of economic uncertainty can quickly undermine a household’s budget.
To guard against these events, households can set aside a portion of their income without an immediate spending goal. This financial reserve constitutes what economists call precautionary savings.
Facing the unforeseen
Precautionary savings refer to the portion of income set aside in order to be able to cope with expenses or income losses that were not foreseen.
It can, in particular, be used to finance a major repair, a health expense, a period of unemployment, a temporary drop in income, or any other event likely to disrupt the budget.
Unlike savings intended to fund a specific project, such as buying a home or preparing for retirement, precautionary savings do not necessarily have a predetermined destination. Its main function is to build a financial cushion.
A behavior influenced by uncertainty
The level of precautionary savings largely depends on the perception that households have of their economic situation and their future.
When uncertainty rises, households may decide to reduce certain expenditures and increase their savings in order to have a reserve in case of difficulty. Conversely, when economic and job prospects are deemed more favorable, they may be more inclined to consume.
This behavior explains why an increase in saving does not necessarily entail an immediate rise in consumption. A portion of additional income may be kept aside in anticipation of future events.
At the level of a household, precautionary savings help strengthen financial resilience and limit recourse to debt in the face of unforeseen events. At the level of the economy, its evolution can however have effects on consumption and thus on aggregate demand.
In periods of high uncertainty, a generalized rise in precautionary savings can then dampen consumption and weigh on economic activity. This notion thus helps connect individual household financial decisions to the major macroeconomic dynamics.
