What Is Precautionary Savings?
Precautionary savings refers to the money set aside by individuals, households, or businesses as a buffer against unforeseen future events or unexpected declines in income. This saving motive is a core concept within household finance and behavioral economics, reflecting a rational response to economic uncertainty. It differs from saving for specific goals like retirement or a down payment, focusing instead on mitigating the financial impact of potential adverse shocks. The primary aim of precautionary savings is to maintain a stable level of consumption even when income streams become volatile or cease temporarily.
History and Origin
The theoretical underpinnings of precautionary savings gained significant traction in economic thought during the mid-to-late 20th century. While earlier economists recognized saving behavior, the explicit formulation of a "precautionary motive" for saving is often attributed to the work of economists like David Levhari and Trygve Haavelmo, and later notably by Robert J. Barro, and further formalized by Miles Kimball. Christopher Carroll's work on "buffer-stock saving" also significantly contributed to the understanding of how individuals manage wealth in the face of uncertain income.
A key development in this theory was the introduction of "prudence" as a characteristic of individuals' utility functions, meaning that people dislike risk and, more specifically, dislike downside risk. This concept suggests that individuals with prudent preferences will save more when facing greater income uncertainty. The chapter "The Precautionary Saving Model" within The Economics of Consumption: Theory and Evidence further elaborates on how this motive for saving helps explain observed economic phenomena, such as why individuals with more volatile incomes tend to save more.4
Key Takeaways
- Precautionary savings are funds set aside to guard against unexpected financial difficulties.
- This saving behavior is primarily driven by future uncertainty regarding income, employment, or unexpected expenses.
- It serves as a form of self-insurance, allowing individuals to smooth consumption during adverse events.
- The level of precautionary savings can be influenced by economic conditions, access to credit, and social safety nets.
Interpreting Precautionary Savings
Interpreting precautionary savings involves understanding the underlying motivations and the factors that influence an individual's or household's decision to accumulate such funds. It is not merely about accumulating wealth but about building a financial cushion to enhance liquidity and resilience. The amount of precautionary savings deemed "sufficient" varies greatly depending on an individual's risk tolerance, income stability, job security, and access to other forms of risk management, such as insurance or social safety nets.
A higher perceived future income uncertainty often leads to a greater desire for precautionary savings. Conversely, factors that reduce perceived uncertainty—like stable employment, comprehensive insurance coverage, or robust government support programs—can lessen the need for extensive precautionary savings.
Hypothetical Example
Consider Sarah, a freelance graphic designer whose disposable income fluctuates based on client projects. Despite having a steady average income, she understands that some months might be slow, or unexpected expenses, like a computer repair or a medical bill, could arise.
Instead of spending all her earnings, Sarah allocates a portion each month to a dedicated savings account. This is her precautionary savings. If she normally earns $5,000 per month but has a slow month where she only earns $2,000, she can draw from her precautionary savings to cover her $3,000 living expenses, ensuring her lifestyle doesn't significantly change. Similarly, if her laptop breaks down and costs $1,500 to repair, her precautionary savings provides the necessary funds without requiring her to go into debt or disrupt her financial planning. Her ability to maintain her financial stability demonstrates the practical utility of her precautionary savings.
Practical Applications
Precautionary savings manifests in various aspects of personal and macroeconomic financial behavior. At the individual level, it often translates into building an emergency fund to cover several months of living expenses or unexpected large costs. This strategic saving contributes to an individual's overall net worth and financial security.
From a broader economic perspective, the collective behavior of precautionary savings can have significant macroeconomic implications. During periods of heightened economic uncertainty, such as recessions or financial crises, households and businesses tend to increase their precautionary savings, which can lead to reduced consumption and investment. For instance, an International Monetary Fund (IMF) working paper noted that "at least two-fifths of the sharp increase in household saving rates between 2007 and 2009 can be attributed to the precautionary savings motive" during the Great Recession, highlighting its role in aggregate saving rates during economic downturns. Fur3thermore, the availability of and access to financial services, such as consumer credit and housing finance, can influence household saving decisions, potentially reducing the need for precautionary saving as individuals gain more flexible ways to manage financial shocks.
##2 Limitations and Criticisms
While the concept of precautionary savings provides a valuable framework for understanding saving behavior, it also has limitations and has faced criticisms. One key critique revolves around the difficulty in precisely quantifying the amount of wealth attributable solely to the precautionary motive. Empirical studies attempting to "Disentangle the Importance of the Precautionary Saving Motive" have found varying results, suggesting that while the motive exists across virtually all households, it may not account for a very large fraction of total capital accumulation at the aggregate level. For example, some research indicates that desired precautionary wealth may represent a relatively small percentage of total net worth.
An1other limitation is that models of precautionary savings often assume rational behavior and access to financial markets, which may not hold true for all individuals. For instance, low-income households may face significant liquidity constraints, making it difficult to accumulate substantial precautionary funds even when the need is high. Furthermore, persistent high levels of precautionary savings across an economy can suppress consumption and dampen economic growth by reducing aggregate demand, particularly during periods when the economy needs stimulation.
Precautionary Savings vs. Emergency Fund
While often used interchangeably, "precautionary savings" is a broader economic and behavioral economics concept, whereas an "emergency fund" is a practical application of that concept in personal financial planning.
Precautionary Savings: This term describes the underlying motive for saving in response to uncertainty about future income or expenses. It's the psychological and economic drive to set aside funds to smooth consumption in the face of potential adverse shocks. It can be a conscious decision or an implicit bias.
Emergency Fund: This is a specific, tangible component of a personal financial strategy, typically a liquid pool of money (often in a savings account) earmarked for unforeseen circumstances like job loss, medical emergencies, or significant home/auto repairs. It's the concrete manifestation of the precautionary savings motive, usually with a defined target (e.g., 3-6 months of living expenses).
The emergency fund is a direct outcome of the precautionary savings motive, designed to address the very uncertainties that drive individuals to save defensively.
FAQs
What types of events necessitate precautionary savings?
Precautionary savings are typically used for unexpected events that could disrupt financial stability. These include job loss, unexpected medical expenses, significant home or vehicle repairs, or other unforeseen financial setbacks that are not covered by insurance or regular income.
How much precautionary savings should one have?
The ideal amount of precautionary savings varies by individual circumstances, but a common guideline for an emergency fund is to have three to six months' worth of essential living expenses readily accessible. Factors influencing this amount include job security, health, dependents, and overall risk management strategies.
Does precautionary savings impact interest rates?
While individual precautionary saving decisions do not directly impact interest rates, the aggregate effect of widespread precautionary saving can influence macroeconomic conditions, including aggregate demand and the supply of loanable funds. This, in turn, can indirectly affect interest rate dynamics within the broader context of business cycles and monetary policy.
Is precautionary savings only for individuals?
No. While commonly discussed in the context of personal finance and household finance, businesses also engage in precautionary saving by retaining earnings or maintaining liquid reserves to insulate themselves from unforeseen operational challenges, market downturns, or supply chain disruptions.