Introduction
What is household finance?
Household finance is the study of how households use financial products to attain their objectives.
For example, your objective may be to buy a house. In order to do this, you would save for a deposit
and you may borrow from the bank. The house itself has elements of being a financial product (it is
an investment).
Real estate lies in the intersection between borrowing and lending as well as has a large
consumption component to it.
Many products and tools are used for borrowing and lending. The most commonly used products are:
1. Traditional loans: mortgages, car loans, student loans, credit cards
2. Stocks, bank accounts, mutual funds
More controversial products are:
1. Payday loans, buy-now-pay-later
2. Structured products
Other tools are the role of advisors and new products such as FinTech.
There are also many factors that affect why people make certain decisions (the “use”):
1. Traditional factors: age, risk preferences, income, wealth
2. Semi-traditional factors: expectations
3. Behavioral biases
4. Culture, religion
5. Attitudes
6. Availability of financial services
7. Cross-country comparisons
Lecture 1
There are two approaches to household finance. Normative household finance is how households
should make financial decisions -> predictions according to theories. Positive household finance is
how households actually make decisions. A framework for thinking about financial decisions is
intertemporal consumption smoothing. A major caution is that it is very hard to define rationality and
what people should do.
Finance allows people to smooth consumption. To understand why people want to smooth
consumption, we have to go back to the utility function: a way to mathematically represent
preferences over bundles of goods. We assume that a consumer chooses the bundle of goods that
,maximizes their utility. The maximum of a function can be derived by taking the derivative, then set it
to 0 and check whether the point you have found is a maxima or a minima. These are utility
representations of bundles of different goods or a single good. But in household finance we are
concerned with utility over consumption or over wealth, and typically just over one good:
1. Utility maximization of the same good over time
2. Utility maximization with uncertain payoffs (for example stocks) -> degree of risk
It is generally focused on utility of wealth, U(W) -> payoffs of investments over time.
Typically with utility functions, we assume that people display positive but
diminishing marginal utility of wealth -> the more money you already
have, the less your satisfaction (but still positive) is with additional money.
This implies a concave utility function.
- 𝑈(𝑊) = 𝑙𝑛(𝑊), 𝑈(𝑊) = 𝑊
- 𝐸(𝑈(𝑊)) = 𝐸( 𝑊) -> linked to calculating the expected wealth
when given uncertain payoffs
This utility function on the right is based on a single period, no risk and uncertainty environment.
Why is the diminishing marginal utility of consumption important? It explains why people want to
smooth consumption.
A person can either be risk averse, risk neutral or risk loving. As seen in the utility function, the person
is risk averse. In general, we assume that most people are risk averse in most matters.
Incorporating uncertainty with discrete payoffs is very easy. Risk attitudes come directly from
weighing each payoff versus the expected payoff. However, in the real world, your risky investments
have a payoff according to a certain continuous distribution. It is possible to get more sophisticated
and include risk as a term in the expected utility calculation:
2 2
- 𝑈(𝑊) = 𝑊 − 𝑏𝑊 -> 𝐸(𝑈(𝑊)) = 𝐸(𝑊) − 𝑏(𝑣𝑎𝑟(𝑊) + 𝐸 (𝑊))
This is useful for real-world investments, where we understand the distribution of outcomes. These
utility functions consider variance of wealth to be a risk that people care about. Consumers do not like
variance.
A key principle of household finance (and for why finance exists) is that people do not simply want to
maximize consumption today, they want to maximize the utility of consumption over their lifetime ->
multi-period expected utility.
The neoclassical consumption model says that consumers maximize lifetime utility of consumption
with some caveats:
1. Future consumption is worth less than consumption today (i.e. it is discounted) and an
impatience parameter determines the degree to which that is true -> people discount future
consumption. This is not related to the shape of the utility curve
2. People can use financial markets to transfer consumption across time and that this transfer
either earns a return or incurs a cost
,The consumer maximizes the sum of the utility of consumption today plus the utility of all future
consumption. They are bound by a budget constraint that is equal to their wealth today plus the
return on the wealth they do not consume today. This is obviously not realistic, as people have
income. Over their lifetimes, consumers consume all their wealth. The utility maximization problem
leads to the Euler equation: a person must be indifferent between consuming an additional unit today
versus saving the money and consuming the unit in the future.
Consumers attempt to maximize lifetime expected utility (from consumption). Financial products
allow for the transfer consumption from one period to another (intertemporal substitution):
1. Deferring consumption = saving (= investing, lending)
2. Bringing forward consumption = borrowing
Financial products and wealth by themselves provide no utility. This framework outlines the role of
financial transactions (saving + borrowing) in intertemporal consumption smoothing.
A general rule-of-thumb on intertemporal preferences is: for the average customer, consumption now
provides more utility than consumption in the future. At the very least, money now is worth more
than in the future. Inflation explains a part of this, but it is mainly due to preferences. Customers will
demand compensation for deferring consumption. This is the interest rate (required rate of return).
This cannot fall below 0%.
Consumers will borrow when the expenses are higher than the income, and they will lend when
expenses are lower than the income. Lending is analogous to saving -> the role of financial
intermediaries (such as banks) is to transform savings into lending. There is a cost to borrowing
(interest rate).
This theory is built on the life-cycle theory: consumers have highly variable lifetime incomes. This
model does not include bequest motives, uncertain life expectancy and medical expenses.
- Childhood: no income, acquire human capital
- University: low/no income, acquire (expensive) human capital
- Working age, pre-children: high income, low expenses
- Working age, post-children: high income, high expenses
- Retirement: low income, low expenses
People would prefer smooth consumption. Diminishing marginal utility of consumption can also be
described as “when consumption during high income periods is worth less than consumption during
low income periods”. Certain investments are best made early -> the value of acquiring human capital
(education) is much higher if acquired when young.
, This figure explains how the financial system facilitates consumption smoothing / insurance of risk.
Household balance sheets show what assets and liabilities people hold. Also, they can be used to
show how characteristics of people affect the composition of these assets and liabilities, such as age,
location and risk preferences. It is important to note that household balance sheets rarely balance.
Most data on household assets and liabilities is very unreliable as it often comes from surveys and it
is difficult-to-measure -> human capital, illiquid wealth (real estate, companies).
Human capital is the largest asset on most balance sheets
and is also called the (discounted) expected value of future
earnings. For most people (especially young), human capital
is the most important element of their personal balance
sheet. The value of human capital declines over time.
Human capital declines over time, but we want to maintain
our consumption. Therefore, we invest in financial assets,
such as stocks and real estate, to try to smooth
consumption -> we convert human capital into financial
capital for future use.
An illustration of individuals’ asset accumulation over
their lifetime is shown. Human wealth is at a maximum
when people graduate university. You probably had to
borrow money to get this education, which thus led to
negative financial wealth. When you enter the working
world, you start putting aside money for your retirement
-> accumulation of financial wealth. This should peak
right before you retire, and after that you have no income,
so it decreases. So, you compensate for the decline of
human capital with financial assets.
The question is whether people actually accumulate financial wealth over time. Asset market
participation seems to match the theory -> the older people get, the more probable they are to
participate in risky asset markets. However, the overall participation rates are low as still not that
many people at an older age have accumulated financial assets.
Next, it depends per household (and
country) what financial assets they hold.
Here, it can be seen that for most countries,
the vast majority is in real estate. Durable
goods are stuff like cars and furniture.
Overall, often under 20-30% of the
households own stocks directly or even
What is household finance?
Household finance is the study of how households use financial products to attain their objectives.
For example, your objective may be to buy a house. In order to do this, you would save for a deposit
and you may borrow from the bank. The house itself has elements of being a financial product (it is
an investment).
Real estate lies in the intersection between borrowing and lending as well as has a large
consumption component to it.
Many products and tools are used for borrowing and lending. The most commonly used products are:
1. Traditional loans: mortgages, car loans, student loans, credit cards
2. Stocks, bank accounts, mutual funds
More controversial products are:
1. Payday loans, buy-now-pay-later
2. Structured products
Other tools are the role of advisors and new products such as FinTech.
There are also many factors that affect why people make certain decisions (the “use”):
1. Traditional factors: age, risk preferences, income, wealth
2. Semi-traditional factors: expectations
3. Behavioral biases
4. Culture, religion
5. Attitudes
6. Availability of financial services
7. Cross-country comparisons
Lecture 1
There are two approaches to household finance. Normative household finance is how households
should make financial decisions -> predictions according to theories. Positive household finance is
how households actually make decisions. A framework for thinking about financial decisions is
intertemporal consumption smoothing. A major caution is that it is very hard to define rationality and
what people should do.
Finance allows people to smooth consumption. To understand why people want to smooth
consumption, we have to go back to the utility function: a way to mathematically represent
preferences over bundles of goods. We assume that a consumer chooses the bundle of goods that
,maximizes their utility. The maximum of a function can be derived by taking the derivative, then set it
to 0 and check whether the point you have found is a maxima or a minima. These are utility
representations of bundles of different goods or a single good. But in household finance we are
concerned with utility over consumption or over wealth, and typically just over one good:
1. Utility maximization of the same good over time
2. Utility maximization with uncertain payoffs (for example stocks) -> degree of risk
It is generally focused on utility of wealth, U(W) -> payoffs of investments over time.
Typically with utility functions, we assume that people display positive but
diminishing marginal utility of wealth -> the more money you already
have, the less your satisfaction (but still positive) is with additional money.
This implies a concave utility function.
- 𝑈(𝑊) = 𝑙𝑛(𝑊), 𝑈(𝑊) = 𝑊
- 𝐸(𝑈(𝑊)) = 𝐸( 𝑊) -> linked to calculating the expected wealth
when given uncertain payoffs
This utility function on the right is based on a single period, no risk and uncertainty environment.
Why is the diminishing marginal utility of consumption important? It explains why people want to
smooth consumption.
A person can either be risk averse, risk neutral or risk loving. As seen in the utility function, the person
is risk averse. In general, we assume that most people are risk averse in most matters.
Incorporating uncertainty with discrete payoffs is very easy. Risk attitudes come directly from
weighing each payoff versus the expected payoff. However, in the real world, your risky investments
have a payoff according to a certain continuous distribution. It is possible to get more sophisticated
and include risk as a term in the expected utility calculation:
2 2
- 𝑈(𝑊) = 𝑊 − 𝑏𝑊 -> 𝐸(𝑈(𝑊)) = 𝐸(𝑊) − 𝑏(𝑣𝑎𝑟(𝑊) + 𝐸 (𝑊))
This is useful for real-world investments, where we understand the distribution of outcomes. These
utility functions consider variance of wealth to be a risk that people care about. Consumers do not like
variance.
A key principle of household finance (and for why finance exists) is that people do not simply want to
maximize consumption today, they want to maximize the utility of consumption over their lifetime ->
multi-period expected utility.
The neoclassical consumption model says that consumers maximize lifetime utility of consumption
with some caveats:
1. Future consumption is worth less than consumption today (i.e. it is discounted) and an
impatience parameter determines the degree to which that is true -> people discount future
consumption. This is not related to the shape of the utility curve
2. People can use financial markets to transfer consumption across time and that this transfer
either earns a return or incurs a cost
,The consumer maximizes the sum of the utility of consumption today plus the utility of all future
consumption. They are bound by a budget constraint that is equal to their wealth today plus the
return on the wealth they do not consume today. This is obviously not realistic, as people have
income. Over their lifetimes, consumers consume all their wealth. The utility maximization problem
leads to the Euler equation: a person must be indifferent between consuming an additional unit today
versus saving the money and consuming the unit in the future.
Consumers attempt to maximize lifetime expected utility (from consumption). Financial products
allow for the transfer consumption from one period to another (intertemporal substitution):
1. Deferring consumption = saving (= investing, lending)
2. Bringing forward consumption = borrowing
Financial products and wealth by themselves provide no utility. This framework outlines the role of
financial transactions (saving + borrowing) in intertemporal consumption smoothing.
A general rule-of-thumb on intertemporal preferences is: for the average customer, consumption now
provides more utility than consumption in the future. At the very least, money now is worth more
than in the future. Inflation explains a part of this, but it is mainly due to preferences. Customers will
demand compensation for deferring consumption. This is the interest rate (required rate of return).
This cannot fall below 0%.
Consumers will borrow when the expenses are higher than the income, and they will lend when
expenses are lower than the income. Lending is analogous to saving -> the role of financial
intermediaries (such as banks) is to transform savings into lending. There is a cost to borrowing
(interest rate).
This theory is built on the life-cycle theory: consumers have highly variable lifetime incomes. This
model does not include bequest motives, uncertain life expectancy and medical expenses.
- Childhood: no income, acquire human capital
- University: low/no income, acquire (expensive) human capital
- Working age, pre-children: high income, low expenses
- Working age, post-children: high income, high expenses
- Retirement: low income, low expenses
People would prefer smooth consumption. Diminishing marginal utility of consumption can also be
described as “when consumption during high income periods is worth less than consumption during
low income periods”. Certain investments are best made early -> the value of acquiring human capital
(education) is much higher if acquired when young.
, This figure explains how the financial system facilitates consumption smoothing / insurance of risk.
Household balance sheets show what assets and liabilities people hold. Also, they can be used to
show how characteristics of people affect the composition of these assets and liabilities, such as age,
location and risk preferences. It is important to note that household balance sheets rarely balance.
Most data on household assets and liabilities is very unreliable as it often comes from surveys and it
is difficult-to-measure -> human capital, illiquid wealth (real estate, companies).
Human capital is the largest asset on most balance sheets
and is also called the (discounted) expected value of future
earnings. For most people (especially young), human capital
is the most important element of their personal balance
sheet. The value of human capital declines over time.
Human capital declines over time, but we want to maintain
our consumption. Therefore, we invest in financial assets,
such as stocks and real estate, to try to smooth
consumption -> we convert human capital into financial
capital for future use.
An illustration of individuals’ asset accumulation over
their lifetime is shown. Human wealth is at a maximum
when people graduate university. You probably had to
borrow money to get this education, which thus led to
negative financial wealth. When you enter the working
world, you start putting aside money for your retirement
-> accumulation of financial wealth. This should peak
right before you retire, and after that you have no income,
so it decreases. So, you compensate for the decline of
human capital with financial assets.
The question is whether people actually accumulate financial wealth over time. Asset market
participation seems to match the theory -> the older people get, the more probable they are to
participate in risky asset markets. However, the overall participation rates are low as still not that
many people at an older age have accumulated financial assets.
Next, it depends per household (and
country) what financial assets they hold.
Here, it can be seen that for most countries,
the vast majority is in real estate. Durable
goods are stuff like cars and furniture.
Overall, often under 20-30% of the
households own stocks directly or even
