Wikipedia defines Ratchet effect as ‘an instance of the restrained ability of human processes to be reversed once a specific thing has happened’.
However, the same effect is not applicable in running as a sport.
A runner trains hard to attain certain threshold level of running a particular distance or pace with ease. The threshold level can be reduced if one is forced to stop running due to unforeseen events such as injury or inconsistency in training , amongst others.
When we consider personal finance, it presents an inverse relationship.
The Ratchet effect indicates that when cash flow of a household reduces, their consumption expenditure does not fall in same proportion.
This could be due to :
- social peer pressure and that human beings are conscious of the society they live in ,and
- they are accustomed to a certain level of –
- consumption, and
- living standard.
Additionally, as one becomes accustomed of a certain lifestyle it becomes extremely difficult to cut down on same in future.
Why does this happen?
- This could be due to escalations in production prices that tend to self-perpetuate. Once productive capacities are enhanced or prices have been raised, it becomes difficult to reverse the same.
- Once prices have risen in lockstep to a rise in aggregate demand, they do not always reverse when that demand falls e.g. fuel, FMCG goods, household electricity consumption, and so on.
What can be done to minimize Ratchet effect?
- Plan your cash flow now – for next 1/2/3/4/5/6/7/8/9/10…. Years
- Have and emergency fund for 12-18 months
- Ringfence your liabilities
- Eliminate debt
- Refrain from revenge spending
Remember cost of living is nominal, its cost of lifestyle which brings in ratchet effect.
Content – Ajeeth Kaushal