On Payday, Consumers Feel a License to Spend

Once their paychecks clear, consumers are more likely to hit the stores, and when they do, to splurge on pricier items — a wrinkle in standard economic theory, but a potential boon for regulators in zero-interest-rate environments.

Kenneth Partridge |  March 4, 2016 | Research Feature
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on pay day, consumers spending spikesIf the line at Starbucks seems extra long on certain days of the month, it could mean that people share more than a collective craving for caramel macchiatos. They might also have the same payday.

According to a new paper from Michaela Pagel, an assistant professor at Columbia Business School, and Arna Vardardottir, of Copenhagen Business School, individuals across the income spectrum spend more on discretionary goods — things like clothes, entertainment, and fast-food meals — on days they get paid.

And we’re not just talking ventis instead of grandes. Using data from Iceland — where nearly all payments are made electronically, making them easily traceable through the popular software application Meniga, which links all of an individual’s banking and credit card accounts to provide a simple overview of income and spending — the researchers found that more than half of the population increases their spending on paydays by over 25 percent,even after controlling for individual, day of the week, and day of the month fixed effects, which capture things like afterwork drinks with colleagues on Fridays, and increased spending around holidays. Individuals are more likely to go shopping and, once they’re out, to spend more than they normally would — a double whammy for the pocketbook.

Standard economic theory holds that individuals should spend independently of income arrivals, but on payday many of us seem to feel a license to spend. That finding holds important implications for fiscal stimulus policies, particularly in the present environment where monetary policy has proven ineffective and interest rates continue to hover near zero.

“In the standard model, you make an optimal plan about how to consume to maximize your overall utility,” Pagel explains. “But it seems like people don’t behave according to this model.”

Historically, economists have attributed such payday spending responses to a lack of cash on hand, due either to a lack of savings, as among the working poor, or to wealth being tied up in houses, cars, and investments, as among the more affluent.

Yet only 3 percent of the population holds less than one day’s worth of spending in savings or liquidity, according to the researchers. Further, consumers’ behavior can’t be attributed to anticipation of future liquidity constraints. If this were a factor, individuals should respond to income payments by socking away cash and building up cushions to weather unforeseen hardships. But the data shows the opposite happens.

Instead, the authors say, it may be a psychological response that causes people to spend on payday. Despite the income being totally expected, the influx gives consumers a momentary feeling of being flush with cash, leading them to splurge on more, and pricier, goods.

“Individuals may consume according to a rule of thumb,” Pagel says. “When they get money, they feel richer, and they feel they can consume some of it. It’s completely understandable from a common-sense standpoint, but it doesn’t make sense according to the economic models. In economic models, people always optimize across time. You shouldn’t see people consuming more just because they have more money one day.”

Firms are aware that income burns holes in people’s pockets, and they’re able to profit from this knowledge. Grocery stores, for example, have been shown to raise prices at the beginning of the month, capturing an enlarged slice of consumers’ end-of-month paychecks. And that’s not the only potential welfare cost for consumers. Dollars spent on payday lattes aren’t going into savings accounts or the stock market, where they might earn a high rate of return.

The bigger issue, though, is how policymakers think about fiscal stimulus. With interest rates still hovering near zero — and even going negative in some countries — the ability of the Federal Reserve and other central banks’ to use monetary policy to stimulate the economy remains limited. One alternative is to send checks to taxpayers in the form of rebates — as the US government did in 2008 — in order to bolster demand and keep the economy from falling into depression. Evidence suggests this works — households consume between 20 and 40 percent of stimulus payments in the quarter they’re received — but the reasons, Pagel says, have always been “kind of a mystery.” Standard economic models suggest that people know stimulus payments will be followed by higher taxes, and yet they spend the money rather than save it.

“The mechanism could be that consumers have no liquid wealth, and some of them therefore consume the fiscal stimulus optimally at very high rates,” Pagel says. “That’s how it’s been described in the literature. But that doesn’t seem to be the right mechanism, not when even individuals with high levels of liquid savings increase their spending on paydays. The mechanism is critical to understand in order to figure out how effective fiscal stimulus could be in a zero-interest-rate environment.”

Michaela Pagel

Michaela Pagel is an Assistant Professor at Columbia Business School. She received her Ph.D. from the Economics Department at UC Berkeley and works on topics in household finance. Her current work focuses on the consumption and investment implications of non-standard preferences. More specifically, she analyzes how decision-making is affected by people's beliefs about their consumption. She tests the implications of these preferences...

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