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The Relationship Between Savings And Economic Growth Economics Essay

When there is a positive change in the level of production of a country’s goods and services over a certain point in time, it is referred to as economic growth. It is also influenced by many factors but one of the pinnacles of economic history is the impact household saving and debt has on economic growth. Most working papers and journal articles on cross country studies assume a positive relationship between household saving and economic growth and an adverse relationship between consumer debt and economic growth.

The difference between a household’s disposable incomes (primarily wages obtained, proceeds of the self-employed and net property returns) and its consumption (spending on products) is known as household saving. When the household saving is divided by household disposable income, the household savings rate is computed. When a household uses more than it obtains as expected income and funds some of the spending through credit (growing debt), through returns coming from the sale of resources, or by making cash and deposits, there is usually a negative savings rate.

The conformist view is that savings contribute to higher investment and hence higher GDP growth in the short run (Bacha, 1990; DeGregorio, 1992; Jappelli and Pagano,1994). The central idea of Lewis’s (1955) traditional development theory was that increasing savings would accelerate growth. Kaldor (1956) and Samuelson and Modigliani (1966) studied how different savings behaviors induced growth. On the other hand, many recent studies have concluded that economic growth contributes to savings (Sinha and Sinha, 1998; Salz, 1999;Anoruo and Ahmad, 2001).

Over the last 10 years, household saving rates have increased in Austria, Germany and Sweden and remained stable in Belgium, France and Switzerland. A downward trend over the same period has occurred in Canada, Italy, Japan, Korea, Poland and the United States. (OECD (2010), National Accounts of OECD Countries, OECD, Paris)


The main factors contributing to differences among countries are listed below:

The income effect: in general higher income leads to a higher saving rate;

The wealth effect: profits or losses on financial and non-financial assets and liabilities affect built up wealth, and thus probably expenditure, but not on income. Higher wealth may then lower the saving rate;

Credit facilities: in countries (e.g. UK and US) where consumption credit was easier to finance, saving rates may be comparatively lower;

Institutional factors such as differences in social security schemes, especially pension schemes and the tax system;

The proportion of own-account entrepreneurs and small unincorporated enterprises, within the household sector, because producers may have a different saving behaviour;

Households' expectations as regards the future economic situation;

Cultural and social factors.

The relationship between savings and economic growth has received increased notice in recent years especially in developed and emerging economies [see Bacha (1990), DeGregorio (1992), Levine and Renelt (1992), and Jappelli and Pagano (1994)]. This might not be distinct to the central foundation of Lewis’s (1955) traditional development theory that increasing savings would accelerate economic growth. Research efforts by Kaldor (1956) and Samuelson and Modigliani (1966) examined how different savings behaviours would induce economic growth.

2.1.1 Theories of Saving The Classicals

The Classicals believe that the rate of interest is the most fundamental determinant of savings and it is determined by the intersection of the investment demand-schedule and the saving-schedule - schedules showing the relation of investment and saving to the rate of interest. Though there is no solution, there is still a way out if the saving schedule’s position is varied with the real income level. As income rises, the schedule will shift to the right as higher reward will be linked with higher supply of “loanable funds”. Thus, the rate of interest is unknown unless the income level is known. However, since we cannot know the income level without already knowing the rate of interest, (as a lower interest rate will mean a larger volume of investment, and so, via the multiplier, a higher level of real income), the classical analysis, therefore offers no solution and is hereby criticized by Keynes about being indeterminate.

This theory emphasizes that higher reward will be linked with higher supply of “loanable funds” and savings are used for investment purposes i.e “loanable funds” will be demanded by investors and there is an inverse relationship between demand for “loanable funds” and the interest rate. Keynes’ Absolute Income Hypothesis

Keynes considers income as the major determinant of consumption and he assumes that in a simple closed model without the government sector and trade, income is in fact equal to consumption plus saving. This theory studies the relationship between income and consumption and emphasizes that the consumption level of a household depends on its absolute level (current level) of income. As income rises, the theory asserts, consumption will also rise but not necessarily at the same rate.

KnSv002.gif Fig 1: Keynes Savings Function

For the household and for the economy as a whole, the savings function is given as St= -a + b Yt

Where St is current savings and Yt is current income

Keynes assumes that when the current income rises, current savings rise by a fraction called the Marginal Propensity to Save (MPS=b) and there is also dissaving when income is zero since consumption is still carried out (-a is the negative intercept term). This linear relationship between current income and current savings is known as the Absolute Income Hypothesis.

CD = a = bYt

 The current level of consumption is a straightforward function, driven by the current level of income.  This implies that people adapt instantaneously to income changes. There is rapid adaptation to income changes and the elasticity of consumption to current income changes.

Divergence between Keynes's predictions and subsequent empirical data, especially over the long run, has led to a number of other theories of consumption—most prominently, those based relative income (Duesenberry), permanent income ( Milton Friedman ), and life-cycle income (Modigliani and Brumberg).

3.1.3 The Relative Income Hypothesis (Duesenberry)

The relative income hypothesis conceives consumption in relation to the income of other households and past income. The first implies that the proportion of income consumed remains constant provided that a household's position on the income distribution curve holds constant in the long run. This is consistent with long-run evidence. Higher up the income curve, however, there is a lower average propensity to consume. The second part of the hypothesis suggests that households find it easier to adjust to rising incomes than falling incomes.

The Duesenberry approach says that people are not just concerned about absolute levels of possession.  They are in fact concerned about their possessions relative to others, “Keeping up with the Jones.”

People are not necessarily happier if they have more money.  They do however report higher happiness if they have more relative to others.

The new utility function would be:

Current economists still support this idea. Ex: Robert Frank and Juliet Schor.

Duesenberry argues that we have a greater tendency to resist spending decreases relative to falls in income than we do to increase expenditure relative to increases of income.  The reason is that we don’t want to alter our standard of living downard.

CT = a +bYT + cYX

YX is the previous peak level of income (this keeps expenditure from falling in the face of income drops).  It is also known as the Drag Effect.

A shift in expenditures relative to a previous level of income is known as the Ratchet Effect, and will be shown below.

Duesenberry argues that we will shift the curve up or move along the curve, but not we will resist shifts down.  When WWII ended, a significant number of economists claimed that there would be a consumption decline and aggregate demand drop which did not occur.  This provides supporting evidence.

A long-run consumption function can be drawn, assuming that there is a growth trend.  If this is true, previous peak income would have been that of last year and thus would give a consumption function that looks like it depends on current income.


3.1.4 Permanent Income Hypothesis

Also explains why there was no drop collapse in spending post WWI.

Friedman argues that it would be more sensible for people to use current income, but also at the same time to form expectations about future levels of income and the relative amounts of risk.

Thus, they are forming an analysis of “permanent income.”

 Permanent Income = Past Income + Expected Future Income

Transitory Income – income that is earned in excess of, or perceived as an unexpected windfall.

So, he argues that we tend to spend more out of permanent income than out of transitory.

In the Friedman analysis, he treats people as forming their level of expected future income based on their past incomes.  This is known as adaptive expectations.

Adaptive Expectations – looking forward in time using past expectations.  In this case, we use a distributed lag of past income.

YPt+1   E(Yt+1) = B0Yt + B1Yt-1 + B2Yt-2…

Where B0 > B1 > B2

It is also possible to add a constraint: B0 + B1 + B2 + B3 + … Bn = 1

This is expected income, the actual income can be thought of as:

Yt-1 – Ypt+1 = Ytt+1

Using this, we can construct a new model of the consumption function:  

Ct = a = bYDt + cYtt

There are other factors that people can look at to think about future levels of income.  For example, people can think about future interest rates and their effect on their income stream.  If you were Friedman, you would do this by using a distributed lag of past incomes.

3.1.5 The Life Cycle Hypothesis

This is primarily attributed to Ando and Modigliani

The basic notion is that consumption spending will be smooth in the face of an erratic stream of income.

Working Phase:

Maintain current consumption, pay off debt from youth years

Maintain current consumption, build up reserves

Age distribution now matters when we look at consumption, and in general, the propensity to consume.  Debt and wealth are also taken into account when we look at the propensity to consume.  The dependence structure of the population will affect or influence consumption patterns. Lester Thurow (1976) – argued that this model doesn’t work because it doesn’t presume there is any motive for building wealth other than consumption.  Thurow argues that their real motivation is status and power (both internal and external to the family). The permanent income hypothesis bears a resemblance to the life-cycle hypothesis in that in some sense, in both hypotheses, the individuals must behave as if they have some sense of the future.


3.2 Other Motives of Saving

The rational motives of saving are basically of three types:

(a) Acquisition of certain durable tangible assets to be used in saver's household (transaction motive);

(b) Provision for certain future expenditures (precautionary motive); and in cases where saver is, or intends to become, an independent businessman, farmer, or professional, or for funeral and related expenses, maintenance of saver and dependents after retirement, estate of surviving spouse, children, and other dependents, specific anticipated expenditures of substantial size compared to current income, e.g. children's education, and establishment of a reserve for undesignated contingencies, that is, a "rainy day."

(c) Altruist motives whereby households save for the future generations.

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