It’s payday. What to do? Spend or save? The temptation to spend is so much bigger. Just the thought that the money’s there, ready to serve you, is thrilling. New research looks at why money burns a hole in people’s pockets.
Assistant Professor Michaela Pagel of Columbia Business School and Arna Vardardottir of Copenhagen Business School authored a new research, which shows that people earning regular and irregular income tend to spend on both necessary and discretionary goods and services as soon as they get paid.
To document payday responses of individuals across their earned income spectrum, the researchers used Iceland data from 2011 to 2015, generated by a personal finance aggregation app called Meniga – Europe’s leading private finance management provider.
This platform allows individuals to manage their bank accounts and credit cards painlessly and see all of them in one single place.
In October 2014, 25 percent of Iceland households were using Meniga, which is currently adopted in 13 countries, with more to join in with banks and financial institutions worldwide. Since almost all payments in Iceland are performed electronically, they are easily traceable through the app.
The research shows that more than half of the population increases spending by more than 25 percent on payday.
The “demographic statistics are remarkably similar to the overall Icelandic population,” write the authors. “The average user is 40 years old, 15 percent of users are pensioners, 50 percent of users are female, 20 percent have children, and 8 percent are unemployed.”
In their in-depth analysis, the authors differentiated between regular and irregular income and studied whether the payday responses are common for a larger part of the population. They explored the margin of spending, finding out that individuals are 11 percent more prone to go on any shopping trip on paydays, spending more than they would on a shopping day when they don’t get paid.
They analyzed possible proxies for financial sophistication starting from age, pensions and employment to banking fees paid, savings and overdraft debt, and whether the spouse is linked, observing that individuals who lose less interest have a higher spending response than those who lose more.
In addition, they performed a series of robustness checks and concluded that spending responses to income arrivals are a very robust phenomenon that is clearly estimated and common throughout the population. They could also approximate the natural tendencies of the sample population to consume in response to payments such as fiscal stimulus.
Furthermore, taking a closer look at liquidity constraints, Pagel and Vardardottir considered that results from previous research suggest such constraints “may not be straightforward to document empirically.” While some households live from paycheck to paycheck and have no savings, others may have a cash cushion for either unforeseen or foreseen expenses.
Because of exceptional data thoroughness, the authors were able to draw an accurate picture of both income and spending categories of the Icelandic population.
They found that many households satisfy their immediate needs even though they may not be liquidity-constrained.
They argue, in contrast to previous studies, that non-liquidity-constrained households do show the behavior of spending on immediate needs based on three liquidity constraints measures: balances and credit limits, spending on discretionary goods, and spending right before income arrival.
They found that only 3 percent of the population have less than one day of average spending left in liquidity before their payday.
It also looks like people don’t tend to optimize their spending over time. Instead, they use experience-based thinking to decide how much to consume and save.
According to Pagel and Vardardottir, consumer buying behavior on a payday doesn’t align with economic models. The authors attribute this to a psychological urge to indulge on payday.
“Economic models predict that consumers have an optimal plan of when to consume what. Whether or not individuals receive perfectly predictable payments should not affect their optimal consumption plan,” Pagel explained.
“The Liquid Hand-to-Mouth: Evidence from Personal Finance Management Software” – by Michaela Pagel and Arna Vardardottir (PDF)
Press Release: On Payday, Consumers Feel A License To Spend