Chapter: 01

Background of the Study

In the most recent decade, financial literacy has turned out to be one of the approach important
points of government offices, keeping money businesses, common people of purchasers and
network premium gatherings, and other associations. There is an incredible worry that customers
tend to do not have working information of financial ideas and don't have the instruments they
have to settle on choices most profitable to their financial prosperity. The low level of financial
literacy can impact a person's or family's everyday cash administration and capacity to put
something aside for long haul objectives, for example, purchasing a home, looking for advanced
education, or financing retirement. Incapable cash administration can additionally result in
practices that make customers more delicate to serious financial emergencies (Braunstein and
Welch, 2002).

The capacity of people to settle on educated financial choices is essential to creating sound
individual finance. This is required to add to more effective designation of financial assets what's
more, to more prominent financial soundness at both the miniaturized scale and full scale level.
accomplishments to enhance financial literacy is additionally an essential pathway to expand
sparing rates and loaning to the poorest and most defenseless purchasers, for example, those
working in casual segments (Klapper et al., 2012).
It contends that illustration the people and firms working in the casual divisions into the formal
financial division would be one of the quickest approaches to encourage financial advancement
in developing markets. This could likewise be the situation for Indonesia where the extent of
center class continues developing and the measure of casual segment in the financial framework
is high. (Cole et al. 2010)
Over the recent years, financial literacy has gained a prominent position in the policy agenda of
many countries. The OECD International Network on Financial Education (OECD/INFE)
defines financial literacy as ‘a combination of financial awareness, knowledge, skills, attitudes
and behaviors necessary to make sound financial decisions and ultimately achieve individual
financial wellbeing’. The importance of collecting informative, reliable data on the levels of
financial literacy across the adult population has also been widely recognized (OECD/INFE
2015).
Financial literacy is defined as “Knowledge and understanding of financial concepts, and the
skills, motivation and confidence to apply such knowledge and understanding in order to make
effective decisions across a range of financial contexts, to improve the financial well-being of
individuals and society, and to enable participation in economic life.” (OECD, 2013)
According to Miller, Godfrey, Levesque, and Stark (2009), financial literacy combines the
investors' and the consumers' understanding related to the deferent products and the concepts and
the ability to take the effective decisions when it is related to the deferent financial concepts. It
makes the people familiar with the different financial terms. At the macro level, individual
savings benefit the whole nation. Savings provide governments with public spending on
development projects and financial intermediaries channelize those savings to fuel business
investments undertaken by companies. Subsequently, an investment by companies brings higher
productivity and efficiency that positively impact economic progress. What is more interesting;
higher savings also hedge countries against economic downturns and financial crises.
The last four decades have witnessed a long-term trend toward disintermediation of retirement
saving and dissaving, as defined benefit pensions have given way to defined contribution plans
all over the world. Such disintermediation efforts can, however, be thwarted by peoples’ lack of
financial sophistication, as attested to by extensive research around the globe on financial
illiteracy (Lusardi and Mitchell, 2014). Moreover, the financially illiterate may have a very
difficult time setting spending goals, paying debt, deciding how much and where to invest,
determining when to stop working and when to claim their Social Security and pension payouts,
and how to handle insurance needs over the lifetimes. It is well documented that those who study
finance, usually save money and make appropriate decision towards investing their surplus funds
(Gale, Harris, & Levine, 2012). In the wake of financial markets integration across the globe, it
is becoming important for the investors to be more aware, competent and knowledgeable in
monitoring and managing their finances.

Introduction
Adequate level of financial literacy is required for financial wellbeing of the individual and
that of the family. It impacts short term requirement like day to day money management as well
as long term requirement like buying home, children education, and secure retirement.
Ineffective money management can also result in behavior that makes consumer more vulnerable
to a financial crisis (Braunstein and Welch, 2002). Insurance and pension plans are important for
ensuring security in retired life. This requires knowledge about the markets, financial products
and also proper attitude as well as behavioral skills. These activities need budgeting, planning
and involve savings and investments.The main reason for why people struggle financially is
because they have spent years in school but learned nothing about money. The result is that people
learn to work for money, but never learn to have money work for them (Kiosaki,2012).
Financial literacy has been recognized as crucially important for individuals, businesses and
society as a whole. Financially literate consumers can make more informed decisions and
demand higher quality services (PISA/OECD,2012). Financial literacy is one of the major factors
affecting the survival rate and growth prospects of start-up companies (Lennox, 2014). Based on
the World Bank’s 2014 Global Financial Development Report (World Bank, 2013), small and
medium-sized enterprises, in particular in emerging markets, face significant financing
constraints that negatively productivity growth and innovation potential. In turn, on the point of
financial experts, financial education is the most effective tool to promote financial inclusion for
households and businesses (ACCA, 2014). The purpose of this article is to examine previous
literature to identify financial literacy measurement models and their similarities and dissimilarities
to design ultimately a country specific financial literacy index for Pakistan.
Financial literacy is a key life skill in any stage of an individual life. Individuals are making
numerous financial decisions in their day to day lives where poor decisions lead to serious financial
problems. Financial illiteracy has been cited by many commentators as a major reason for falling
saving rates (Hilgert, Hogarth and Beverly, 2003), mounting consumer debt (Stango and Zinman,
2007), inadequate planning for retirement (Lusardi and Mitchell, 2006), and mismanagement of
personal finances (Kotzè and Smit, 2008). It should be emphasized that everyone of a country should
be financially literate. Such financial literacy is an imperative aspect of solving basic financial
problems emerging in contemporary modern society.
Financial literacy is decided by the needs of a person, experience, and expertise, and may have a
constructive effect on the personal involvement of customers in the services offered by the
financial system. Further, it is the personal capability to make informed decisions about the
management and employment of funds (Lusardi & Scheresberg, 2013).
Financial literacy is recognized to be crucially important also for businesses. The direct benefits
from financially awareness of customers can get financial services providers. Financially literate
consumers can make more informed decisions and demand higher quality services, which will
encourage competition and innovation in the market (PISA/OECD, 2012). Owners and managers
of start-up companies also have a high demand for financial literacy, since it is one of the major
factors affecting the survival rate and long-term prosperity (Lennox, 2014).
Thus, in the authors’ opinion, the concept of financial literacy involves six obligatory elements
that should be considered within the structure of all dimensions:
- Savings-borrowings. Related questions are: knowing about savings alternatives, ability to
evaluate different types of savings accounts, knowing about the procedures of borrowing, debt
literacy, and ability to plan ahead.
- Personal budgeting. Related questions are: knowledge of principles of personal budgeting,
understanding of budget balance, knowing about taxation impact on personal income and etc.
- Economic issues. Related questions are: understanding about the economic situation in a
country and worldwide, knowing economic and financial terms, economic ratios and etc.
- Financial concepts. Understanding of basic financial concepts - for instance, time value of
money and relationship between investment risk and return.
- Financial services. Knowledge about financial products and services, such as payment cards,
insurance, online services and others.
- Investing. Knowledge about investment opportunities and understanding of the related risks.
Increasing financial literacy and capability promotes efficient personal financial outcomes, thus,
enables better management of life events, such as, higher education, illness, housing, marriage
and / or retirement planning. This research is mainly related with the financial literacy among the
individuals of Pakistan, since it is important that Pakistani's must have the awareness related to
the different important financial concepts
Chapter: 02

2 Literature Review

2.1 Defining and Measuring Financial Literacy

In literature the term Financial Literacy is interchangeably used with financial capability and
economic literacy (Lusardi, and Mitchell, 2014). Some researchers consider it as a necessary
skill which is regarded as ability to get and use financial information, which can be measured
through understanding of financial concepts and through financial performance (Mason and
Wilson, 2000). According to Murray (2010), it is a set of capabilities such as general literacy,
problem solving ability, numerical ability applied to personal finance. Financial Literacy is
relative in the sense that it is specific to socioeconomic conditions of the people and is linked to
their specific problems such as exclusion. One of the most commonly used definitions of
financial literacy was proposed by the Organization of Economic Co-operation and Development
(Atkinson & Messy, 2011): [Financial literacy is a] „combination of awareness, knowledge,
skills, attitude, and behaviors necessary to make sound financial decisions and ultimately achieve
individual financial wellbeing”.
The multi-dimensionality of the concept of financial literacy has been recognized by various
researchers (Hung,Parker, & Yong, 2009; PISA/OECD, 2012).
Huston (2010) in a study measuring financial literacy showed that a person who is financially
literate, that is he/she has the knowledge and the ability to utilize the knowledge, may not exhibit
predicted behaviors or increases in financial well-being because of certain influences. Such
impacts could come from behavioral/cognitive biases, self-control problems, family, economic,
community, and institutional factors. However, Sabri, Cook, & Gudmunson (2012) found that
financial literacy significantly influenced students’ perceived financial well-being. Taft, Hosein,
Mehrizi & Roshan (2013) in their study on financial literacy, financial well-being, and financial
concerns revealed that higher financial literacy leads to greater financial well-being. Thus, for
financial well-being to be achieved financial literacy is needed.Financial advice can also help
with estate planning and tax management (Cici et al., 2017).
Alternative findings are presented by Christelis, Jappelli, and Padula (2010) that the respondents
belonging to Europe got the low scores in the financial market participation due to low financial
literacy index.Financial literacy can be explained as the procedure through which individuals
manage their finances in terms of savings, investing, budgeting and insurance covering (Boyland
&Warren, 2013).
Additionally, researchers argued that being assured and well-informed in the domains of spend-
ing, budgeting and savings are the most important elements of financial literacy. The level of
financial knowledge should react on the quality of individuals' life (Boyland & Warren, 2013).
The financial literacy is viewed as an answer to the financial complications that individuals and
Households have to face (Huston, 2010).

It is also identified that financially literate individuals will have an idea as to how they control
their financial now, comprehend how the financial institutions are functioning and have a wide
range of logical and systematic skills (Landerretche & Mart__nez, 2013). Moreover, financial
awareness identifies how individuals need to tackle their financial issues and how to be more
responsible financially. In some studies, financial literacy has been defined as the knowledge and
comprehension of the fundamental concepts of finance and the capacity to apply them to manage
and plan the funds in the most effective and efficient manner (Taft, Hosein, Mehrizi, & Roshan,
2013).

Ellis, Lemma, and Rud (2010) conducted survey in the OECD countries related to the Financial
literacy and the behaviour. The study focused at the income, education and the age, and those
factors were considered significant determinants to the financial literacy across the 14 countries.
However, Gender was not the important factor among the 6 countries when financial literacy was
considered.
Meier and Sprenger (2013) have explained that the different economists and policymakers have
argued that financial literacy is the main element when it is related to the financial
improvementBut still the problem is despite the importance many individuals still do not have
the required knowledge about the financial terms and matters and are seen to be illiterate. In their
work they have presented the deferent results by conducting a held study in which the different
decisions of the individuals are considered to determine about the financial literacy. Contrary to
the broad evidence, they and that the people who are more financially literate are seen to be
attaining less financial benefits than those who are financially less literate.
Today, easier access to the credit cards, lower transaction costs, free own of capital in many
financial markets and the advancement in technology through which financial services are
allocated / offered has certainly left many consumers / investors with the perplex selection about
investing their surplus funds and where to invest (Drexler, Fischer, & Schoar, 2014). Moreover,
the literature suggests that there is a sturdy association between the household welfare and the
financial knowledge. Studies show that the households having a low degree of financial literacy
tend not to make a plan for their future or retirement, own lower levels of assets, and often
borrow at a higher rate of interest (Gale et al., 2012).

Additionally, these findings have inuenced many policy makers in both developed and develop-
ing economies to augment their efforts in improving financial literacy that can improve the
savings rate and facilitate the participation of households in the financial markets, which
subsequently en- hances the efficiency of businesses and decreases the level of poverty (Lusardi
& Mitchell, 2014).
At the macroeconomic level, savings of individuals benefits the whole nation and promotes their
well-being as well (Lusardi & Mitchell, 2014). Savings has a constructive impact on the
country's economy in general as funds that are allocated to the financial assets are then
transported via inter- mediaries to fund the investments by businesses. Those investments by the
organizations ultimately contribute towards the economic development and productivity. In
addition, higher savings rate may provide a cushion to the countries against the financial crisis
and economic recession (Meier & Sprenger, 2013).
One of the ways to increase the national savings rate is by educating the people about the
benefits of personal savings (Meier & Sprenger, 2013). This can be attained by launching the
programs on financial education and to increase the financial literacy of the individuals, i.e., to
facilitate them to prepare the financial plans for their future, and select the more suitable
financial tools that will aid them to attain their financial goals and objectives. Brockman and
Michayluk(2015) also document that Australians with low levels of financial literacy have lower
savings rate.Through individual surveys, they also observed noted differences between financial
literacy and savings rate across income levels & age groups; and between genders. Since, one of
the objectives of this paper is to investigate the relationship of financial literacy across income,
gender, age, family size, etc., it is hypothesized that greater degree of financial literacy entails
that people who have better knowledge of their economic and/or financial circumstances are
capable of planning their future well, therefore make more informed financial decisions
(Boisclair, Lusardi, & Michaud, 2014).Different authors assess different components of financial
literacy based on their subjective interpretation of the concept. For example, an in-depth analysis
of the level of financial literacy of Australian citizens was carried out in the research by the
Australian government «Financial Literacy: Australians’ Understanding Money» [4]. Seven
components of financial literacy were analyzed: budget, saving, investing, credit and debt,
planning and retirement, protecting money, information and advice. Within «The 2012
Consumer Financial Literacy Survey» conducted in the USA [15], the level of financial literacy
was analyzed considering nine components of the concept: budget, bills, and debt, getting
money; savings; spending; credit; credit cards and mortgage.