Unit 9 Lenders and borrowers and differences in wealth
9.2 Income and wealth
- investment
- Investment is expenditure undertaken in order to generate a return in future: for example, buying financial assets that will generate income in future, or a house that will provide accommodation, or capital goods to be used by a firm to produce output. In the national accounts, investment expenditure refers more specifically to fixed investment (gross fixed capital formation) together with inventory investment. See also: fixed investment, inventory investment.
- wealth
- The stock of things owned, or value of that stock. Wealth may generate income, or contribute to the owner’s wellbeing in some other way. It includes the market value of a home, car, any land, buildings, machinery, or other capital goods that a person may own, and any financial assets such as shares or bonds. To calculate wealth, debts are subtracted—for example, the mortgage owed to the bank. Debts owed to the person are added.
- shares, stocks
- Shares (also known as stocks) are financial assets that can be bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a right to receive a corresponding share of the firm’s profit.
- human capital
- The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in human capital, through education, training, and socialization can increase the stock. Human capital is part of an individual’s endowment. See also: endowment.
- income, disposable income
- Income, also known as disposable income, is the amount of profit, interest, rent, labour earnings, and other payments (including transfers from the government) received, net of taxes paid, measured over a period of time such as a year. Your income is the maximum amount that you could consume per period and leave your wealth unchanged.
Understanding borrowing, lending, and investment requires some terms—like wealth and income—that are in common use but are used in a precise way in economics.
Wealth
Wealth is the value of things that you own that contribute to your well-being in some way, called assets. Households invest in assets, including houses, works of art, and financial assets like shares, to ‘save’ or ‘accumulate’ wealth. The assets can either provide an income, for example the rents, profits, interest, or dividends from physical and financial assets you own, or provide other valued services, for example the transport and accommodation made possible by your vehicle and home. If you own intellectual property (such as patents, trademarks, and copyrights) these are also part of your wealth. A work of art is an asset that may appreciate in value, and at the same time, provide pleasure on the wall of your sitting room. Debts require you to make payments to others, and therefore count as negative wealth.
The term wealth is also sometimes used in a broader sense to include your health, skills, and ability to earn an income (your human capital). But we will use the narrower definition of material wealth in this unit, since we focus on forms of wealth that can potentially be turned into spending on goods and services.
Income
Your income is the maximum amount that you could spend over a given period of time without reducing your wealth, for example by selling some of what you own or by borrowing (remember taking on a debt by borrowing reduces your wealth). This includes what you receive as:
- earnings (wages or salaries from labour)
- profits, interest, dividends, and rents from assets that you own
- any increase or decrease in the value of those assets (called capital gains and losses)
- transfers from the government minus taxes paid.
In this unit, we simplify by not considering taxes as a deduction from one’s income, or transfers from the government as an addition.
- earnings
- Wages, salaries, and other income from labour.
- flow
- A quantity measured per unit of time, such as weekly income, or annual carbon emissions. See also: stock.
- stock
- A quantity measured at a point in time, such as a firm’s stock of capital goods, or the amount of carbon dioxide in the atmosphere. Its units do not depend on time. See also: flow.
- depreciation
- No definition available.
- saving
- When consumption expenditure is less than net income, saving takes place and wealth rises. See also: wealth.
- bond
- A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
Since it is measured over a period of time (such as weekly or yearly), income is a flow. Wealth is a stock, meaning that it has no time dimension. At any moment of time it is just there.
To highlight the difference between wealth and income, think of filling a bathtub, as in Figure 9.1. Wealth is the amount (stock) of water in the tub, while income is the flow of water into the tub. The inflow is measured by litres (or gallons) per minute; the stock of water is measured by litres (or gallons) at a particular moment in time.
Figure 9.1 Wealth, income, depreciation, and consumption: the bathtub analogy.
Income either adds to wealth (in which case it is termed saving) or is used for consumption spending.
Some wealth takes physical forms, such as a car or office equipment. The value of physical wealth tends to decline, either due to use or simply the passage of time. This reduction in the value of a stock of wealth over time is called depreciation. Using the bathtub analogy, depreciation is the amount of evaporation of the water. In economics, an example of depreciation is the fall in the value of a car with mileage and with age. Like income, depreciation is a flow (for example, you could measure it in dollars per year for a car or computer), but a negative one.
In order to take account of depreciation, economists distinguish between income (which is net of depreciation) and gross income. The flow of income into the bathtub is gross income.
A person’s wealth will affect the opportunities they have for borrowing and investing. This is the reason why we focus on wealth (and wealth inequalities) in this unit rather than income and income inequalities.
Consumption and saving
Water also flows out of the tub. The flow through the drain is called consumption, and it reduces wealth just as income increases it. Consumption refers to household spending on goods and services.
An individual (or household) saves when consumption is less than net income, so wealth increases. Wealth is the accumulation of past and current savings. Saving can take a number of forms, for example, putting money into bank deposits, or buying financial assets, such as shares (also known as stocks) in a company, or bonds issued by a government or a company in the financial markets. The choice about where and how to save depends on the relative returns that you can earn and on how easy it is to turn the savings back into money for consumption. Purchases of shares or bonds are often done on behalf of the individual by another organisation, most often the company that runs their personal pension fund who will have more expertise on what to buy and when. The decisions about how much money to save in each saving option will depend on what the expected return is, which will depend on the riskiness of the asset. Returns in asset markets are generally higher for assets that are considered higher-risk. Contributions to a personal pension fund are an example of the use of savings to buy financial assets.
- government bond
- A financial asset where the government borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
When a government’s spending is greater than its tax revenue, it borrows by issuing bonds. A government bond is generally considered to be a safe asset because it is a promise from the government to pay some fixed amount to the holder of the bond on a given schedule over a fixed period of time, and because it is assumed that the government will not default on the payments.
When companies plan to spend more than their revenue (for example, on the purchase of machinery and equipment), they have a number of choices. They can borrow from banks (bank loans), borrow from the public by selling company bonds, or sell part of the company (shares). A company is more likely to default on its payments to bondholders than is the government. This higher risk of default means that it is generally more expensive for firms to borrow than it is for the government. The return that a bondholder searches for will be higher to compensate for the higher risk relative to government bonds—in other words, company bonds are riskier than government bonds.
Read Extension 9.2 for more details on the characteristics of bonds and shares.
Shares are literally a share in the ownership of a company. The holder owns some fraction of the company’s buildings, equipment, intellectual property, and other assets. As a part owner of the firm, the shareholder also owns a share of the profits of the firm. The value of a share fluctuates depending on how profitable the firm is and is expected to be in the future. Shares therefore differ from bonds in two important respects: there is no promised payment to the holder (it depends on how profitable the firm is), and there is no fixed maturity period for the ownership of a share (it may be held for a lifetime). For these reasons, shares are a riskier type of savings or class of asset than are company bonds, which in turn are riskier than government bonds due to the higher risk of default.
Question 9.1 Choose the correct answer(s)
Read the following statements and choose the correct option(s).
- Human capital, such as your health, skills, and ability to earn an income, is immaterial wealth.
- Income minus depreciation is the flow that corresponds to your stock of wealth, so if you consume it all, your wealth is unchanged.
- Both companies and governments can borrow from the public by issuing bonds. The bond issuer promises to pay a given amount over time to the bondholder.
- Depreciation is the loss in value through wear and tear or the passage of time.
Question 9.2 Choose the correct answer(s)
Freny Mistry has wealth of £800,000. To make this example more realistic, we introduce an income tax. There is no wealth tax in this economy. She has a market income of £60,000 per year, on which she is taxed 25%. Her wealth includes some equipment, which depreciates by £4,000 every year. Based on this information, read the following statements and choose the correct option(s).
- Her after-tax income is her market income less tax, which is £60,000 × 0.75 = £45,000.
- Her net income is her after-tax income minus depreciation, which is £45,000 – £4,000 = £41,000.
- £41,000 is her net income. Consuming this amount does not alter her wealth. However, she can also consume all of her wealth, so her maximum possible consumption expenditure is £800,000 + £41,000 = £841,000.
- A 70% portion of her net income is £28,700, leaving £12,300 to spend on investment.
Differences in types of debt and assets (wealth) of poor and rich households
This unit explains how a person’s situation—especially how much wealth they have—affects the borrowing and lending opportunities open to them. Their choice will depend on what is feasible and on their preferences. Before providing a model to shed light on this choice, we present information on the debts and assets of poor and rich households.
- equity
- Shares (stocks) in a business are known collectively as equity. The total value of the equity held by the shareholders is equal to the net worth of the business, and an individual shareholder’s equity in the business is the total value of the shares they own. The term equity is also used more generally for a share of ownership of any asset, and for the net worth of any household, business, or project. There is a second entirely different use of the term, meaning fairness, as in ‘an equitable division of the pie’. See also: net worth
Figure 9.2 shows the types of debt (what is owed to others) and assets (what is owned by the household) for the four quarters (quartiles) of US households ordered by their net wealth. In the figure, ‘Equity in businesses’ refers to ownership stakes in particular businesses whereas ‘Directly held stocks’ refers to the ownership of shares traded on the stock exchange.
The most striking feature of the figure is that the wealthiest quarter of US households own 97.7% of the shares that are directly held and of equity in businesses. The poorest quarter have virtually none of these assets and even the third wealthiest quarter of the population own very little equity or stocks. Stocks and equity are held almost exclusively by the richest quarter of Americans.
On the debt side, the poorest quarter, which includes a lot of young people, hold more than their proportional share in education loans (56.5%). Otherwise their participation both in borrowing (as reflected in debt shares) and in saving (as reflected in asset shares) is much lower than their share in the population. Note that they hold 4.7% of residential (or mortgage) debt and only 1.7% of residential home equity. It is only the richest quarter whose share of residential home equity is greater than their share of debt.
To explore more data on wealth inequality in the US and other countries, try this interactive visualization.
Figure 9.2 Who owns what? Who owes what?
Top: Proportion of total debts and assets in the economy held by each quartile of the population in 2019. The poorest quartile holds 25% of total net worth (assets – debts) in the economy.
Bottom: Distribution of total debt and assets in the US economy.
Source: Federal Reserve System. 2021. Survey of Consumer Finances.
Question 9.3 Choose the correct answer(s)
Based on the two bar charts and two pie charts in Figure 9.2, read the following statements and choose the correct option(s).
- The first fact is shown in the first bar chart and the second is shown in the first pie chart. Putting them together, we deduce that this statement must be true. In fact, the first row of the bar chart shows that the richest quartile has almost half of all debt.
- The least wealthy quartile (as noted in the text—this group contains many young people) has more than half of educational loan debt. But educational loan debt—although the third largest category—makes up a relatively small share of total debt. Overall, the poorest quartile has far less than 25% of total debt.
- The poorest quartile has a higher percentage share of vehicles than they do of any other asset category, and vehicles is the category with the smallest overall share of total assets.
- The third quartile’s shares of equity in business and directly held stocks are very small. Their share of life insurance and retirement accounts is slightly higher, but still very small. Almost all of these assets belong to the highest quartile.