An Empirical Time Series Analysis on the Determinants of Gross National Saving in Ethiopia. ARDL Approach for Co-integration

Table of Contents

Abstract

ACKNOWLEDGMENTS

Table of Contents

List of Figures

List of Tables

List of Appendices

List of Acronyms and Abbreviations

Chapter One Introduction
1.1. Background of the Study
1.2. Statement of the Research Problem
1.3. Objective of the Study
1.3.1. General Objective
1.3.2. Specific Objectives
1.4. Significance of the Study
1.5. Scope of the Study
1.6. Hypothesis of the Study
1.7. Limitation of the Study
1.8. Organization of the Study

Chapter Two Literature Review
2.1. Theoretical Literature Review
2.1.1. Measurement Issues
2.1.2. Saving and Consumption Smoothing
2.1.2.1. Franco Modigliani and the Life-Cycle Hypothesis
2.1.3. Saving, Interest Rate and Economic Growth
2.1.3.1. Harrod - Domar Growth Model
2.1.3.2. Saving and Economic Growth
2.1.3.3. The Importance of Saving
2.1.3.4. Changing the Rate of Saving
2.1.3.5 How Changes in the Real Interest Rate Affect Consumption and Saving
2.1.4. Saving and External Sector
2.1.5. Saving and Macroeconomic Policies
2.1.6. Saving and Institutional Considerations
2.1.6.1. Financial Intermediation and Capital Markets
2.1.6.2. Compulsory Public Pension Schemes
2.1.7. More on Microeconomic Foundations of Saving
2.1.7.1. Saving Motives of Individual Households
2.1.7.1.1. Retirement Motive
2.1.7.1.2. The Bequest Motive
2.1.7.1.3 Precautionary Motive
2.2 Empirical Literature Review

Chapter Three Source of Data and Model Specification
3.1. Type and Source of Data
3.1.1. Type of Data and Variable Description
3.1.1.1. Dependent Variable
3.1.1.2. Explanatory Variables
3.1.2. Source of Data
3.2. Method of Data Analysis
3.3. Model Specification
3.3.1. Test for Cointegration (Bounds Test)
3.3.2. Long Run Representation of the ARDL Model
3.3.3. Short Run Representation of the ARDL Model
3.4.1 Unit Root Test
3.5. Lag Length Selection Criterion

Chapter Four Overview of the Ethiopian Economy and Gross National Saving
4.1. Macroeconomic Performance in Ethiopia
4.2. Trend of Gross National Saving Over Time (1970/71 to 2010/11)
4.3. Trend of Gross National Saving Ratio, Gross Fixed Capital Formation as share of GDP and Saving Gap Overtime
4.4. Gross National Saving ratio, Nominal Deposit Interest Rate and Growth in Gross National Disposable Income
4.5. Gross National Saving ratio, Financial Development and Macroeconomic Stability
4.6. Gross National Saving and Fiscal Policy
4.7. Gross National Saving and External Sector

Chapter Five Empirical Analysis and Estimation
5.1. Description of the data set used in Estimation
5.2. Unit Root Test
5.3. Bounds Test for Co-integration
5.4. Long Run Representation of the Auto-Regressive Distributed Lag Model (Bounds Test Approach)
5.5. Short Run Representation of the ARDL Model Bounds Test Approach (Error-Correction Representation)
5.6. Determinants of Gross National Saving in the Study (Expected Vs Actual Sign)
5.7. Diagnostic Test
5.8. Model Stability – The CUMSUM Test

Chapter Six Conclusions and Policy Recommendations
6.1. Conclusions
6.2 Policy Recommendations

Reference

Appendices

Abstract

An Empirical Time Series Analysis on the Determinants of Gross National Saving in Ethiopia: ARDL Approach for Cointegration

Yohannes Ghebru Alemayehu

Addis Ababa University, 2014

The objective of this paper was to investigate the macroeconomic determinants of gross national saving in Ethiopia using time series annual data form 1970/71-2010/11. In this study, effort has been made to identify the long run and short run determinants of national saving in Ethiopia using an ARDL bounds testing approach and ECM to capture both short run and long run relationships. Estimated results revealed that financial development (FD) and Current account deficit (CAD) are significant determinants of gross national saving in Ethiopia in the long run. But gross national disposable income (LGNDI), dependency ratio (DR), budget deficit (BD) and inflation, approximated by consumer price index (CPI), found to be statistically insignificant determinants of gross national saving in Ethiopia in the long run.

However, in the short run, except consumer price index (CPI) and dependency ratio (DR) the rest of the explanatory variables such as gross national disposable income (LGNDI), financial development (FD), current account deficit (CAD) and budget deficit (BD) found to have statistically significant meaning in explaining gross national saving in Ethiopia. The speed of adjustment has value 0.66978 with negative sign, which showed the convergence of saving model towards long run equilibrium. The overall findings of the study underlined the importance of raising the level of income in a sustainable manner, minimizing the adverse impacts of budget deficit and inflation rate and creating competitive environment in the financial sector.

ACKNOWLEDGMENTS

Words are powerless to express my praises and adoration to the Almighty God for his love, comfort, strength, mercies and favor. The strength and guidance of God alone have enabled me to complete this MA program in Economics.

I am deeply indebted to my advisor Dr. Fantu Guta for his guidance and valuable comments throughout the development of this project. He has unfailingly provided thoughtful ideas and detailed considerations of all the steps in the process that lead to this final work. At times he has been incredible for me, every time I visit his office his welcoming face makes things easy at all. I also have to acknowledge that this study has benefited a lot from a brief discussion with Dr. Syed Hassen.

I would like to extend my sincere gratitude to Department of Economics of Addis Ababa University. My heartfelt thanks go to Ministry of Finance and Economic Development for sponsoring my study with a regular payment of monthly salary. My special thanks go to Dr. Abraham Tekeste and Azeb Meles who extended their unwavering support with all they have.

I take this opportunity to express my heartfelt gratitude to all my beloved family members, especially, to my Dad and Mom for encouraging and surviving me through the years.

I would like to thank Neguse Kahsay Msc Student Addis Ababa University, Mawek Tesfaye from National Bank of Ethiopia, and Solomon Mosisa from Ethiopian Economics Association for generously providing me all the data I need and sharing valuable ideas throughout the study. Last but not least, I would like to give my heartfelt appreciation and gratitude to all my friends.

List of Figures

Figure 1. Trend in Gross National Saving Ratio

Figure 2.Trend of Gross National Saving ratio, Gross Fixed Capital Formation as share of GDP and Saving Gap

Figure 3. Trend in Gross National Saving Ratio, Nominal Deposit Interest Rate and Growth in Gross National Disposable Income

Figure 4. Trend in Gross National Saving Ratio, Consumer Price Index and Financial Development

Figure 5. Gross National Saving Ratio and Fiscal Policy

Figure 6. Gross National Saving Ratio and External Sector

Figure 7. Plot of Cumulative Sum of Recursive Residuals

Figure 8. Plot of Cumulative Sum of Squares of Recursive Residuals

List of Tables

Table 1. Overview of Ethiopian Economy

Table 2.Trend of Gross National Saving

Table 3. Summary Statistics

Table 4. Results of Augmented Dickey Fuller Test

Table 5.Results of Phillips—Peron Test

Table 6.Results of F-Test or variable addition test for Cointegration

Table 7. Results of Estimated long run model

Table 8. Estimated results of the Short Run Model

Table 9. Hypothesized and actual sign obtained after estimation

Table 10. Results for the various Diagnostic Tests

List of Appendices

Appendix 1: Estimates of Long Run Model

Appendix 2: Estimates of Short Run Model

Appendix 3: Diagnostic Tests

Appendix 4: Variable Used in Empirical Analysis at Level and First Difference

Appendix 5: Gross National Saving and Terms of Trade (Harberger-Lasrsen-Metzler effect)

List of Acronyms and Abbreviations

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Chapter One Introduction

1.1. Background of the Study

Saving the other side of consumption is vital for the development process of a nation. Again saving what is left after consumption governs the growth path of a country. The more the peoples of the nation saves the more resources are available for investment there by accelerating economic growth. The recent success story in terms of economic growth achieved in Ethiopia has attracted much attention towards how the huge investments are financed in the process analyzing the role of gross national saving on investment.

The remarkable recent growth performance was supported by robust investment—but not matched by similarly high savings rates. The gap between Gross Domestic Savings (GDS) and the investment rate widened over the past three decades. Investment rose from 15.7 percent of GDP in the 1980s to 23 percent in the 2000s, while Gross Domestic Savings declined from 10.5 percent to 6.1 percent of GDP over the same period. Recent revisions in the national accounts of Ethiopia indicate a growing savings rate again over the past years. Investment financing has shifted gradually away from gross domestic savings towards net income transfers, foreign direct investment, and external borrowing. In the 1980s, gross domestic savings mostly financed investment. In the 2000s, an expansion of investment was made possible by an increase in net income transfers and a larger current account deficit (financed, in turn, by FDI and external borrowing) (Ethiopia Economic Update II, World Bank, 2013).

Saving has always figured prominently in both theoretical analysis and policy design in both developed and developing economies. This prominence emanates from its assumed direct theoretical link to future economic growth and current expenditure levels via its link to consumption. Early theories of economic growth emphasized the role of saving as a source of capital accumulation and hence growth. Similarly the aggregate demand based theory of Keynesian economics also focused on aggregate expenditure which has a direct implication to saving. Due to their preoccupation with short-term macroeconomic adjustment and stabilization policies, the emphasis on saving was relatively neglected in the 1980s in many African countries. But the focus on economic growth and hence on saving seems to have resurfaced in the 1990s and after. This interest is partly due to the belief that one of the reasons for slow growth in Sub-Saharan Africa is the low rate of saving relative to other developing regions (Alemayehu Geda and Haile Kibret, 2007).

The behavior of economic agents in the allocation of economic resources is a critical factor that exerts influence on the growth path of a country. One of such allocation issues is concerned with the inter-temporal allocation of income between consumption and saving. The behavior and determinants of such allocation decision are important to understand the mechanisms and interactions across aggregate consumption, saving, capital accumulation and growth processes. In fact, economic policies in most countries attempt to influence the level and growth of these variables so as to achieve growth in productivity and employment, macroeconomic stability and efficient resource allocation.　The efficacy of such policies, however, depends on the nature and degree of influence that policies have on these macroeconomic variables (Abu, 2004).

One of the areas towards which public policies have been directed is improving the domestic saving rate of national economies. The rationale of the policy is that saving serves as a source of capital formation which in turn influences the productivity of labor and its growth over time. The fact that investment would be financed either from current or future saving of a national economy coupled with the imperfect international mobility of capital in general and to developing countries in particular, implies that improving domestic saving rate is an important policy target. This lends to the question of what kind of public policies are effective in encouraging domestic saving (Abu, 2004).

Despite the importance of saving for economic growth, saving rate is lower to finance the domestic investment in most developing countries. Sub-Sahara Africa has low gross domestic saving (18% of its GDP) when compare to South Asia, 26% and newly industrialized countries 43% in 2005 (IMF, 2007). For Ethiopia, during the imperial era, gross domestic saving as a percent of GDP was 11% on average. After the socialist state took power in 1974 there were expectations towards the increment of saving by eliminating the luxury life style of the ruling classes. In actual fact the policy of imposing capital ceiling became a serious disincentive to saving class and further encouraged conspicuous consumption (Befekadu and Birhanu, 2000). Instead of increasing, what turned out during the Derg regime was the ratio of gross domestic saving (GDS) as percent of GDP has declined from 11% to 4% on average, while further show a very haphazard rate during the entire Derg regime from high of 7% in 1976-1986 to even less than 1% during the last period of the Derg regime as a consequence of increasing government consumption on military expenditure (Dawit, 2004).

Spurred by the sound economic policy and favorable weather condition, the Ethiopian economy witnessed on encouraging overall economic performance for the last decade as real GDP grew by two digits. Despite this promising and sustainable economic growth performance, gross domestic saving still does not show substantial progress in the same years as it was 4.26 for the period of 2004-2008 with increasing resource gap (NBE, 2008). Ethiopia continues to face a potential shortage of resource to finance public and private investment, which constraints its ability to accelerate economic growth. The chronic resource gap shown is from imbalance between domestic saving and domestic investment. The resource shortage adversely affect ability of government to undertake expenditure in infrastructure and social service to boost domestic demand, encourage private activities and sustain high level of economic growth (ECA, 2006).

Being one of the least developed countries, Ethiopia is experiencing high economic growth and low saving making the nation more dependent on foreign aid and loans from abroad to finance its huge investment requirements which in turn makes Ethiopia exposed to external shocks and other political restrictions. So mobilizing the required saving and making to finance investment is a must.

1.2. Statement of the Research Problem

When one talk’s about a Nations Wellbeing he/she is absolutely talking about development, that is, weather the nation is developed or underdeveloped. One can ask a question here “What brings economic development? “. Behind development there is always impressive and sustainable economic growth story in a sense that remarkable and sustainable economic growth leads towards development.

Ethiopia’s development efforts in the last decade were very impressive. Ethiopia has been involved in implementing mega investment projects like building dams, railways, roads and so on by developing a comprehensive successive five year growth and transformation plans. Financing these hydro investment projects in different sectors requires mobilization of large national saving. The nation no longer needs to depend on the international development assistance and loans from the international organizations like the World Bank and other lenders to finance its projects because of the unpredictable nature of aid and the political interest of the donor nations. So mobilizing the required resources to finance its investment projects and then foster development makes the nation less dependent on aid on the road and provides the nation the much needed freedom to invest according to its plans and fulfill the needs of its people.

Ethiopia’s domestic savings rate is low compared to the fast pace of capital accumulation observed between 2003/04 and 2010/11. Ethiopia has been experiencing single-digit domestic saving rates while economic growth was in double digits, supported by investment rates beyond 25 percent of GDP. Consequently, Ethiopia is confronted with a persistent and wide domestic saving and investment gap, which has been financed by external sources. The Government of Ethiopia has very ambitious public investment plans. Given the current levels of domestic and external savings, however, it may be difficult to finance this investment plan (Ethiopia Economic Update II, World Bank, 2013).

To achieve alarm rate and sustainable economic growth, without any doubt, there is a need for massive and sustainable investment (Private and Public) in the economy. Investment plays a vital role in accelerating economic growth in every nation which ultimately leads to development and wellbeing of the nation. So to have massive and sustainable investment to build the required capital the nation needs to mobilize huge resources, that is, saving (Private and Public Saving). Therefore, the ultimate source of development and a nation’s wellbeing is saving, in as such a way that, more saving leads to more investment and there by higher economic growth which in turn fosters development.

In Ethiopia, the saving culture is very poor relative to other developing economies and that necessitates the need to put in place a coherent economic policy that will be capable of providing the much needed enabling environment and also there is an urgent need to encourage Ethiopians to change their current attitude towards saving, thereby placing the right saving culture by institutions and regulatory agents who influence the decisions of households, firms and government. For instance, during the period 1991 to 2000, domestic savings averaged 6.2 % of Gross domestic product (National Economic Accounts data, 2012) and however this is due to the fact that the low rate of interest rate in the financial sector of the 1990s and saving culture of the people. The impressive economic growth registered and eventually rise in income in the last decade resulted in trivial rise in domestic saving in the period 2000 to 2011 with the saving to GDP ratio rising to 6.6 %.( National Economic Accounts data (NAD), 2012).

Ethiopia, a none oil exporter nation, has registered remarkable economic growth in the last decade averaged around 11 % which makes the nation one of the fastest growing countries in the world. The country is now day’s a busy nation in eradicating poverty and achieving development. So it’s quite simple to think that how saving has been playing a key role in what Ethiopia has achieved in terms of real growth in output in the last decade and this economic growth puts Ethiopia on the verge of development.

With the rate of savings standing at only 2.5% in Ethiopia in 2006 (National Economic Accounts data, 2012), there is the need to examine the main constituents of savings in Ethiopia. So manipulating carefully the macroeconomic environment national policy generates variables which could influence the propensity of economic and financial actors to save.

As most of the determinants of saving studies are dominated by panel regression techniques and cross country data country specific studies are relatively few in numbers and studies in this area are two scanty in Ethiopia. So this paper tries to fill gaps and make contributions to the determinants of saving literature. More specifically, this thesis would attempt to examine from policy perspectives, the magnitude and direction of such variables as: gross national disposable income, financial development (measured by currency as share of narrow money), dependency ratio, inflation (measured by consumer price index), current account deficit and budget deficit on savings in Ethiopia. In addition to this, studying the determinants of gross national saving will help to understand and know the factors which affect the mechanisms of saving and produce sound macroeconomic policies to mobilize large saving and there by accelerate economic growth and ultimately bring development.

To summarize, this thesis will discuss on the determinants of mechanisms of saving in the case of Ethiopia. And bring out the factors that determine gross national saving in Ethiopia which there by aid to develop comprehensive macroeconomic policies that will mobilize the much needed saving.

1.3. Objective of the Study

The study has general and specific objectives. The specific objectives are within the framework of the general objective, in a sense that, they are set up in as such a way to achieve the general objective.

1.3.1. General Objective

The general objective of the study is to figure out the main macroeconomic determinants of gross national saving in Ethiopia.

1.3.2. Specific Objectives

- To observe the trend of gross national saving in Ethiopia overtime.
- To examine the role Gross National Saving on Gross Fixed Capital Formation.
- To examine the long run and short run determinants of gross national saving in Ethiopia.

1.4. Significance of the Study

Most of the previous studies conducted on the determinants of gross national saving have given focus on panel data analysis, it can be said that time series analysis has been numbered. On the other hand, Time series studies conducted exert much effort on cross country analysis i.e. there are no plenty country specific studies undertaken. Furthermore, the choices of the variables that influence gross national saving and thereby included in the past studies are not comparable to our country situation. This study will attempt to focus on the determinants of saving with more relevant variables to the Ethiopian economy case. Furthermore, the study will be significant in a sense that, given the current activities of investment of the Ethiopian government, it will help to figure out the main variable that determine saving thereby manipulate these variables to create the macroeconomic environment to mobilize the required saving rather than depending on external sources to finance investment.

1.5. Scope of the Study

This thesis will discuss about the determinants of saving in Ethiopia. The study aims to provide a better understanding of the short run and long run determinants of saving in Ethiopia. Moreover, the study will focus only on the macroeconomic variables that govern saving and ignores the microeconomic determinants of saving, that is, household level determinants of saving analysis will be ignored.

1.6. Hypothesis of the Study

There are an awful lot of variables that determine the level of saving in a given country. With regard to our country Ethiopia more specific variables are thought to be the main determinants of gross national saving. The paper need to put the expected results or hypothesis on the impact of six explanatory variables on the level of gross national saving. Therefore, in this study it is expected that:

- Gross national disposable income has a positive impact on the level of gross national saving.
- Financial development, which is measured as currency over narrow money, has negative impact on gross national saving.
- Dependency ratio, which is a demographic variable, has a negative impact on the level of gross national saving.
- Consumer price index, which is an indicator of the level of inflation, has a negative impact on the level of gross national saving.
- Current account deficit, which is an indicator of the external sector, has negative impact on the level of gross national saving.
- Budget deficit, which is an indicator of the fiscal policy, has a negative impact on the level of gross national saving.

1.7. Limitation of the Study

Due to the unavailability of time series demographic data like urbanization which is relevant in explaining the behavior of national saving the researcher is not able to include such demographic variables. In addition to this there are also data limitations on some variables. The accuracy of the data is again a limitation to the study since the inconsistency of data collected on the same variable from different institutions is unbelievable. Even though shortage of data and inconsistency of data limit me to do the study, I will try to afford those limitations and do my best to maximize.

1.8. Organization of the Study

The rest of the study is organized in as such a way that. Section two reviews the theoretical and empirical literature related to saving. In section 3, the data used and econometric methodology used for empirical framework are described. In section 4, overview of Ethiopia economy and trend in gross national saving is discussed by focusing on the variables in clouded in the analysis and those attempted to be included in the analysis. Section 5, reports the results of the empirical analysis in detail and section 6 provides conclusion and policy implication.

Chapter Two Literature Review

2.1. Theoretical Literature Review

This chapter presents the recent literature in area of saving and its possible implication in the economy. The chapter begins by a review of theoretical literature in which theoretical frameworks are explained. The empirical literature section reviews the major works at the international level and shows how far has been done in Ethiopia to the best of the researcher’s knowledge. Last but not least, the researcher tried to cover the available theoretical and empirical works on national saving to his best knowledge.

2.1.1. Measurement Issues

It has to be noted from the outset that data problems in examining saving behavior both at the macro-economic and micro-economic levels, particularly in developing countries, are pervasive. For instance, at the macro-economic level, “saving is not measured directly but is the residual between two large magnitudes [GDP and Consumption], each itself measured with errors (Deaton, 1989, cited in Alemayo Geda and Haile Kibret, 2007)”. Similarly, at the micro-economic level, “The standard household survey may well understate saving. The concept of income is itself extraordinarily complex, and most people in developing countries have little reason to distinguish between business and personal cash transactions” (Deaton,1989, cited in Alemayo Geda and Haile Kibret,2007).

These difficult national accounts data issues notwithstanding, it is apparent that domestic and national savings are dominated by private savings, and that household savings form the more substantial part of these in most countries (Deaton 1989). Household savings may be measured in a number of ways. One approach is provided by the flow-of-funds perspective (Wilson, et.al. 1989), in which the capital expenditures of households are added to their acquisition of financial assets in the first instance. Any changes in their liabilities are subtracted from this to yield their gross personal saving. An allowance for capital consumption yields the net personal saving in the flow-of-funds account. Making further deductions for spending on consumer durables and income adjustments yields personal saving by the flow-of-funds approach on the same conceptual basis as measured by the national income and product accounts approach. Data limitations, however, make it difficult to measure the household saving rate by the flow-of-funds approach in almost all African countries. The National Income and Product Approach in which expenditure is subtracted from income is therefore widely used (Ernest Aryeetey and Christopher Udry, Saving in Sub-Saharan Africa, 2000).

Aryeetey and Udry (1999) also note that in the case of Sub-Saharan Africa, non-financial assets (livestock, stocks of goods for trading, grain and farm inputs) dominate their asset portfolios which in essence are used to smooth out consumption over time. What is more, due to distortions in the trade sector that results in illegal capital outflow (via over-invoicing of imports and under-invoicing of exports, for instance), saving will be underestimated when calculated as the sum of trade and government surpluses and domestic investment (Deaton, 1989). Analysis of saving behavior in the absence of the above considerations therefore will make it inaccurate and in their presence complex (Cited in Alemayo Geda and Haile Kibret, 2007).

2.1.2. Saving and Consumption Smoothing

Choices by individuals and families about their saving are one set of fundamental determinates of national savings. These decision makers divide the current increment to their resources between consumption, the satisfaction of current wants, and savings that intern will influence their ability to satisfy wants in the future. Any model of rational decision –making by savers must, therefore, focus very explicitly on the trade-off between satisfying wants now and later with in this limitation, however, there is considerable latitude for different specifications of consumer’s objectives and the constraints they face in attaining them. The researcher starts with a very simple Franco Modigliani’s life cycle hypothesis model of intertemporal decision making about consumption.

2.1.2.1. Franco Modigliani and the Life-Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani and his collaborators Ando and Richard Brumberg used Fisher’s model of consumer behavior to study the consumption function. One of their goals was to solve the consumption puzzle—that is, to explain the apparently conflicting pieces of evidence that came to light when Keynes’s consumption function was confronted with the data. According to Fisher’s model, consumption depends on a person’s lifetime income. Modigliani emphasized that income varies systematically over people’s lives and that saving allows consumers to move income from those times in life when income is high to those times when it is low. This interpretation of consumer behavior formed the basis for his life-cycle hypothesis (Mankiw, 2009).

The point of departure of the life cycle model is that the hypothesis that consumption and saving decisions of households at each point of time reflects a more or less conscious attempt at achieving the preferred distribution of consumption over the life cycle, subject to the constraint imposed by the resources accruing to the household over its lifetime (Franco Modigliani, 1966, 162).

The Hypothesis

One important reason that income varies over a person’s life is retirement. Most people plan to stop working at about age 65, and they expect their incomes to fall when they retire. Yet they do not want a large drop in their standard of living, as measured by their consumption. To maintain their level of consumption after retirement, people must save during their working years. Let’s see what this motive for saving implies for the consumption function (Mankiw, 2009).

Consider a consumer who expects to live another T years, has wealth of W, and expects to earn income Y until she retires R years from now. What level of consumption will the consumer choose if she wishes to maintain a smooth level of consumption over her life? (Mankiw, 2009).

The consumer’s lifetime resources are composed of initial wealth W and lifetime earnings of R × Y. (For simplicity, we are assuming an interest rate of zero; if the interest rate were greater than zero, we would need to take account of interest earned on savings as well.) The consumer can divide up her lifetime resources among her T remaining years of life. We assume that she wishes to achieve the smoothest possible path of consumption over her lifetime. Therefore, she divides this total of W + RY equally among the T years and each year consumes

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We can write this person’s consumption function as

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For example, if the consumer expects to live for 50 more years and work for 30 of them, then T = 50 and R = 30, so her consumption function is

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This equation says that consumption depends on both income and wealth. An extra $1 of income per year raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year (Mankiw, 2009).

If every individual in the economy plans consumption like this, then the aggregate consumption function is much the same as the individual one. In particular, aggregate consumption depends on both wealth and income. That is, the economy’s consumption function is

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where the parameter α is the marginal propensity to consume out of wealth, and the parameter b is the marginal propensity to consume out of income (Mankiw, 2009).

Because wealth does not vary proportionately with income from person to person or from year to year, we should find that high income corresponds to a low average propensity to consume when looking at data across individuals or over short periods of time. But over long periods of time, wealth and income grow together, resulting in a constant ratio W / Y and thus a constant average propensity to consume (Mankiw, 2009).

To make the same point somewhat differently, consider how the consumption function changes over time. For any given level of wealth, the life-cycle consumption function looks like the one Keynes suggested. But this function holds only in the short run when wealth is constant. In the long run, as wealth increases, the consumption function changes. This upward shift prevents the average propensity to consume from falling as income increases. In this way, Modigliani resolved the consumption puzzle posed by Simon Kuznets’s data (Mankiw, 2009).

The life-cycle model makes many other predictions as well. Most important, it predicts that saving varies over a person’s lifetime. If a person begins adulthood with no wealth, she will accumulate wealth during her working years and then down her wealth during her retirement years. According to the life-cycle hypothesis, because people want to smooth consumption over their lives, the young who are working save, while the old who are retired dissave (Mankiw, 2009).

2.1.3. Saving, Interest Rate and Economic Growth

2.1.3.1. Harrod - Domar Growth Model

Every economy must save a certain proportion of its national income, if only to replace worn-out or impaired capital goods (building, equipment and materials). However, in order to grow, new investment representing net additions to the capital stock are necessary. If we assume that there is some direct economic relationship between the size of the total capital stock, K, and total GDP, Y—for example, if $3 of capital is always necessary to produce a $1 stream of GDP—it follows that any net additions to the capital stock in the form of new investment will bring about corresponding increases in the flow of national output, GDP. Suppose that this relationship, known in economics as the capital-output ratio, is roughly 3 to 1. If we define the capital-output ratio as k and assume further that the national net saving ratio, s, is fixed proportion of national output and that total new investment is determined by the level of total savings, we can construct the following simple model of economic growth (Michael P. Todaro and Stefen C. Smith, Economic Development, 2009).

1. Net saving (S) is some proportion, s, of national income (Y) such that we have the simple equation

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2. Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that

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But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as expressed by the capital-output ratio, k, it follows that

Or

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Or, finally,

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3. Finally, because net national savings, S, must equal net investment, I, we can write this equality as

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But from equation 3.1 we know that S = sY and from equation 3.2 and 3.3 we know that

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It therefore follows that we can write the “identity” of saving equaling investment shown by equation 3.4 as

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Or simply as

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Divide both sides of Equation 3.6 first by Y and then by k, we obtain the following expression:

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Note that the left hand side of Equation 3.7, ΔY/Y, represents the rate of change or rate of growth of GDP.

Equation 3.7, which is a simplified version of the famous equation in the Harrod - Domar theory of economic growth, states that the rate of growth of GDP (ΔY/Y) is determined jointly by the net national saving ratio, s, and the national capital-output ratio, k. More specifically, it says that in the absence of government, the growth rate of national income will be directly or positively related to the saving ratio (i.e. the more the economy is able to save – and invest out of a given GDP, the greater the growth of the GDP will be) and inversely or negatively related to the economy’s capital-output ratio (i.e. the higher k is, the lower the rate of GDP growth will be) (Michael P. Todaro and Stefen C. Smith, Economic Development, 2009).

The Harrod-Domar model, points out that output depends on the investment rate and the productivity of that investment. In an open economy, investment is financed by domestic saving and foreign savings. This model explains economic growth in terms of a saving ratio and capital-output coefficient.

2.1.3.2. Saving and Economic Growth

If you have ever spoken to your grandparents about what their lives were like when they are young, most likely you learned an important lesson about economic growth: material standards of living have improved substantially over time for most families in most countries. This advance comes from rising incomes, which have allowed people to consume greater quantities of goods and services (Mankiw, 2009).

The question of growth is nothing new but a new disguise for an age-old issue, one which has always integrated and preoccupied economics: the present and the future.

--- James Tobin

Economic growth theories like the Solow growth model explain why our national income growth, and why some economies grow faster than others, by making broaden analysis so that is describes the changes in the economy overtime. The Solow growth model shows how saving, population growth and technological progress affect the level of an economy’s output and its growth overtime (Mankiw, 2009). Here in the Solow growth model the role of saving in economic growth is clear.

The Solow growth model shows that the saving rate is a key determinant of the steady state capital stock. If the saving rate is high the economy will have a large capital stock and high level of output in the steady state. If the saving rate low, the economy will have a small capital stock and a low level of output in the steady state. This conclusion sheds light on many discussions of fiscal policy. As it’s already known that government budget deficit can reduce national saving and crowd out investment. The long run consequences of a reduced saving rate are a lower capital stock and lower national income. This is why many economists are critical of persistent budget deficit (Mankiw, 2009).

What does the Solow model say about the relationship between saving and economic growth? Higher saving leads to faster growth in the Solow model, but only temporarily. An increase in the rate of saving raises growth only until the economy reaches the new steady state. If the economy maintains a high saving rate, it will maintain a large capital stock and a high level of output, but it will not maintain a high rate of growth forever. Policies that alter the steady-state growth rate of income per person are said to have a growth effect. By contrast, a higher saving rate is said to have a level effect, because only the level of income per person—not its growth rate—is influenced by the saving rate in the steady state (Mankiw, 2009).

Now having understood how saving and growth interact, we can more fully explain the impressive economic performance of Germany and Japan after World War II. Not only was their initial capital stocks low because of the war, but their steady-state capital stocks were also high because of their high saving rates. Both of these facts help explain the rapid growth of these two countries in the 1950s and 1960s (Mankiw, 2009).

2.1.3.3. The Importance of Saving

Because capital is a produced factor of production, a society can change the amount of capital it has. If today the economy produces a large quantity of new capital goods, then tomorrow it will have a larger stock of capital and be able to produce more of all types of goods and services. Thus, one way to raise future productivity is to invest more current resources in the production of capital (Principles of Macroeconomics, 2004).

One of the Ten Principles of Economics is that people face tradeoffs. This principle is especially important when considering the accumulation of capital. Because resources are scarce, devoting more resources to producing capital requires devoting fewer resources to producing goods and services for current consumption. That is, for society to invest more in capital, it must consume less and save more of its current income. The growth that arises from capital accumulation is not a free lunch: It requires that society sacrifice consumption of goods and services in the present in order to enjoy higher consumption in the future. The financial market will coordinate saving and investment. In addition to this, the government policies influence the amount of saving and investment that takes place. At this point it is important to note that encouraging saving and investment is one way that a government can encourage growth and, in the long run, raises the economy’s standard of living (Principles of Macroeconomics, 2004).

2.1.3.4. Changing the Rate of Saving

In order to move any economy toward the Golden Rule steady state, policymakers should increase national saving. But how can they do that? That is, as a matter of sheer accounting, higher national saving means higher public saving, higher private saving, or some combination of the two. Much of the debate over policies to be taken to increase growth focuses on which of these options is likely to be most effective. The most direct way in which the government affects national saving is through public saving—the difference between what the governments receives in tax revenue and what it spends. When its spending exceeds its revenue, the government runs a budget deficit, which represents negative public saving. A budget deficit raises interest rates and crowds out investment; the resulting reduction in the capital stock is part of the burden of the national debt on future generations. Conversely, if it spends less than it rises in revenue, the government runs a budget surplus, which it can use to retire some of the national debt and stimulate investment. The government also affects national saving by influencing private saving—the saving done by households and firms. In particular, how much people decide to save depends on the incentives they face, and these incentives are altered by a variety of public policies. Many economists argue that high tax rates on capital—including the corporate income tax, the federal income tax, the estate tax, and many state income and estate taxes—discourage private saving by reducing the rate of return that savers earn. On the other hand, tax-exempt giving preferential treatment to income saved in these accounts. Some economists have proposed increasing the incentive to save by replacing the current system of income taxation with a system of consumption taxation. Many disagreements over public policy are rooted in different views about how much private saving responds to incentives. For example, suppose that the government were to increase the amount that people can put into tax-exempt retirement accounts. Would people respond to this incentive by saving more? Or, instead, would people merely transfer saving already done in other forms into these accounts—reducing tax revenue and thus public saving without any stimulus to private saving? The desirability of the policy depends on the answers to these questions (Mankiw, 2009).

To summarize, the Solow growth model shows that in the long run, an economy’s rate of saving determines the size of its capital stock and thus its level of production. That is, the higher the rate of saving the higher the stock of capital and then, the higher the level of output. In the Solow model, an increase in the rate of saving has a level effect on income per person: it causes a period of rapid growth, but eventually that growth slows as the new steady state is reached. Thus, although a high saving rate yields a high steady-state level of output, saving by itself cannot generate persistent economic growth. The level of capital that maximizes steady-state consumption is called the Golden Rule level. If an economy has more capital than in the Golden Rule steady state, then reducing saving will increase consumption at all points in time. By contrast, if the economy has less capital than in the Golden Rule steady state, then reaching the Golden Rule requires increased investment and thus lower consumption for current generations (Mankiw, 2009).

2.1.3.5 How Changes in the Real Interest Rate Affect Consumption and Saving

Let’s now use Fisher’s model to consider how a change in the real interest rate alters the consumer’s choices. There are two cases to consider: the case in which the consumer is initially saving and the case in which he is initially borrowing. An increase in the real interest rate rotates the consumer’s budget line around the point and, thereby, alters the amount of consumption he chooses in both periods. Here you can see that first-period consumption falls and second-period consumption rises. Economists decompose the impact of an increase in the real interest rate on consumption into two effects: an income effect and a substitution effect (Mankiw, 2009).

The income effect is the change in consumption that results from the movement to a higher indifference curve. Because the consumer is a saver rather than a borrower (as indicated by the fact that first-period consumption is less than first-period income), the increase in the interest rate makes him better off. If consumption in period one and consumption in period two are both normal goods, the consumer will want to spread this improvement in his welfare over both periods. This income effect tends to make the consumer want more consumption in both periods. The substitution effect is the change in consumption that results from the change in the relative price of consumption in the two periods. In particular consumption in period two becomes less expensive relative to consumption in period one when the interest rate rises. That is, because the real interest rate earned on saving is higher, the consumer must now give up less first-period consumption to obtain an extra unit of second-period consumption. This substitution effect tends to make the consumer choose more consumption in period two and less consumption in period one. The consumer’s choice depends on both the income effect and the substitution effect. Because both effects act to increase the amount of second-period consumption, we can conclude that an increase in the real interest rate raises second-period consumption. But the two effects have opposite impacts on first-period consumption, so the increase in the interest rate could either lower or raise it. Hence, depending on the relative size of income and substitution effects, an increase in the interest rate could either stimulate or depress saving which is ambitious (Mankiw, 2009).

2.1.4. Saving and External Sector

In the case of open economies, the determinants of saving are more complex. For instance, even ex-post saving may not equal investment as long as there is no constraint to capital flow across national boundaries. For instance, capital inflows in the form of concessional loans and foreign aid have an impact on national saving. As noted earlier, the usual rationale for granting aid or concessional loans has been to augment domestic saving (Alemayo Geda and Haile Kibret, 2007).

A related issue usually considered in the literature as influencing saving behavior is changes in terms of trade, otherwise known as the Harberger-Laursen-Metzler effect. At a theoretical level, this effect is examined in an inter-temporal optimization model. Accordingly, this theory predicts that a temporary improvement in terms of trade would lead to an increase in saving by increasing temporary income or wealth. But the effect of permanent changes in terms of trade on saving is ambiguous (Dayal-Gulati and Thimann, 1997, Schmidt-Hebbel et al, 1996).

2.1.5. Saving and Macroeconomic Policies

In principle government policy could have a potentially significant influence on national saving either by directly increasing public saving or implementing policies that increase private saving. Such policies include, “revenue policy (tax structure, tax incentives), expenditure policy (transfers, income redistribution), and the degree of government saving,” (Dayal-Gulati and Thimann, 1997). Government policy directed at financial and pension reforms could also potentially affect private saving, in addition to the above routes through which government could influence national saving.

In addition to fiscal deficits, governments could also potentially influence private saving by introducing tax incentives, as noted above. By raising the after-tax rate of return governments could in principle encourage private saving. But the final outcome on national saving is ambiguous because it decreases public saving and if the tax is selective it may lead to portfolio reshuffling to gain from the tax break thereby introducing distortions. The existing available literature seems to shed no light on this issue. Similarly, whether direct income transfers and income redistribution positively affect total (national) saving or not is ambiguous at a theoretical level. That is unless the marginal propensity to save between low income groups on the one hand and between the government and the private sector on the other varies significantly, they may offset each other and hence have no impact on total saving (cited in Alemayo Geda and Haile Kibret, 2007)

Other government policies that may affect saving include financial reform, pension reform and macro-economic instability. Financial reform that results in an increase in interest rate is likely to encourage saving (McKinnon, 1973 and Shaw, 1973) argument. Another potentially relevant determinant of saving is macro-economic instability. Since saving is an inter-temporal decision, how economic agents view the future real value of their wealth affects their saving decisions. For instance, inflation (proxy for macroeconomic instability) reduces the real value of financial assets. Therefore, inflation expectation could discourage saving and encourage consumption and/or lead to portfolio reshuffling away from financial assets.

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