Demand for emergency savings is higher for low-income households, but so is the cost of shocks

Abstract

This paper examines how the precautionary motive varies with income. I first develop a theoretical benchmark of how we would expect precaution to vary with income starting from a basic version of the buffer-stock model. Emergency savings provide a way for households to smooth over shocks and so give insight into the precautionary motive. Using data from the Survey of Consumer Finances in the USA, I show that as income declines, the desired emergency savings relative to income increase, suggesting that low-income households are more precautionary. Observable differences, such as income uncertainty, do not explain the rise. Instead, I propose and estimate a model with a minimum subsistence level and unexpected expenses. The model implies that low-income households are increasingly exposed to shocks, explaining the increase in precaution. Supporting the approach, I show that expenses on repairs are a larger fraction of the spending of low-income households.