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Abu Girma - Determinants domestic savings in Eth

Abu Girma - Determinants domestic savings in Eth

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On the Determinants of Domestic Saving in Ethiopia
Abu Girma MogesPaper prepared for the Second International Conference on the Ethiopian EconomyEthiopian Economic AssociationJune 3-5, 2004
On the Determinants of Domestic Saving in Ethiopia
Abu Girma Moges
The domestic saving rate in Ethiopia has been too low to sustain robust capital accumulation andeconomic growth in the country. The saving rate has also been declining over time with far reachingimplications on the growth and poverty reduction prospects of the country. This paper examines thetheoretical and empirical issues and forces in the determination of domestic saving in the country. It arguesthat the fiscal and monetary policies, the investment regime, and external factors interact exerting their respective influence on the behavior of economic agents and the domestic saving performance of thecountry.
Key Words: saving, economic policy, growth,JEL classification: D91, E21, E62
1. Introduction
The behavior of economic agents in the allocation of economic resources is acritical factor that exerts influence on the growth path of a country. One of suchallocation issues is concerned with the inter-temporal allocation of income between consumption and saving. The behavior and determinants of suchallocation decision are important to understand the mechanisms and interactionsacross aggregate consumption, saving, capital accumulation and growth processes. In fact, economic policies in most countries attempt to influence thelevel and growth of these variables so as to achieve growth in productivity andemployment, macroeconomic stability and efficient resource allocation.
Theefficacy of such policies, however, depends on the nature and degree of influence that policies have on these macroeconomic variables.1.2.One of the areas towards which public policies have been directed is improvingthe domestic saving rate of national economies. The rationale of the policy isthat 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 befinanced either from current or future saving of a national economy coupled withthe imperfect international mobility of capital in general and to developingcountries in particular, implies that improving domestic saving rate is animportant policy target. This lends to the question of what kind of public policiesare effective in encouraging domestic saving.
There are a number of hotly contested theoretical and empirical issues in theanalysis of aggregate saving. There is no one paradigm that can explainaggregate saving behavior across countries and over time. First, the link betweensaving decisions at household level and aggregate saving and the accumulationof productive capital is not well established. The behavior of households in their inter-temporal allocation of resources reflects on national consumption andsaving through aggregation process. The aggregation process can conceal criticalfactors and diversities across households creating a less representative picture of 
the allocation process. Second, the relationship between domestic saving andinvestment is not clear. This has both theoretical and empirical aspects. Oneaspect of the argument, which traces its roots to Keynesian economics, contendsthat thrift is a potential threat to the economy as it reduces one importantcomponent of aggregate demand, consumption, without systematically andautomatically increasing the other component, investment. This disconnectionmight lead to inadequate aggregate demand and unemployment of resources inan economy. Other views emphasize on the critical role of saving in capitalaccumulation process and its importance in influencing long run growth performance. From empirical perspective, the correlation between domesticsaving and domestic investment has been strong, indicating weakness of international capital mobility. Third, the empirical oriented researches on theresponsiveness of aggregate saving to real interest rate, one of the variablesamenable to policy measures, have not found robust results in line with thetheoretical predictions. Fourth, there are some indications that suggest the behavior of aggregate saving is subject to the level of development of theeconomy. Addressing these issues and understanding the relationship between policy variables and aggregate saving, investment and growth therefore appeal both from theoretical, empirical and policy perspectives.1.4.The saving rate, which finances the dominant share of capital accumulation,exhibits remarkable variations across countries and over time and there is astrong association between the saving rate and growth performance. Thesefeatures raise a number of issues. How do economic agents make their decisionswith respect to allocating their income between consumption and saving? Doeconomic agents respond to incentives and relative prices in their savingdecision? What is the role of public policies and incentives in influencing thesaving behavior and hence the saving rate? What policies and institutionalfactors are effective in promoting national saving rate? These are some of theissues that are important in understanding the behavior of aggregate saving ratein a country over time.
The decision of economic agents to save is guided by a set of behavioral,economic, psychological and policy factors. The empirical oriented research onthe behavior of domestic saving rate has been dominantly conducted on the basisof cross country analysis of consumption-saving behavior of economic agents.Whereas such an approach is important to draw comparative perspective andnecessitated by the nature of information, such exercise on countries with quitedifferent institutional structures, level of economic and financial development, is problematic in a number of ways. This shortcoming suggests the need to a closeexamination of the factors, dynamics and policies towards saving in a country.Such an approach provides a framework in which to analyze the factors that arerelevant to the context and underlying impulse of an economy.1.6.The subject of analysis in this paper is the domestic saving performance of Ethiopia during the period stretching from 1960/61 to 2002/03. The examination

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