The Empirical Investigation on Determinants of National

Saving in Ethiopia: OLS Approach

By
Degefe Anulo
This thesis is prepared for Partial Fulfillment of Bachelor
Degree of Arts in Faculty of Business and Economics in
Economics Department.

June, 2015
Wachemo University
Hossena, Ethiopia
Abstract
Understanding the nature of national saving behavior is critical in designing policies to promote
savings and investment which in turn enhance economic growth through capital formation. Main
objective of this paper is empirically examining the determinants of national saving in Ethiopia
for the 1980-2016 periods. The existing studies on saving have mostly investigated the long run
and short association of different variables with domestic saving, even if the most of them were
investigated the shock between national saving and economic growth by using ARDL approach.
Whereas no known study has investigated both long run and short run determinant variables that
against national saving by using data of Ethiopia, so this study filled this gap by using ordinary
least square method (OLS) to against major determinates of national saving. The conceptual
framework for the paper is derived from the life-cycle/permanent income hypothesis. Augmented
Dickey Fuller test is used to test stationarity of all time series. The long run and short run
estimates are investigated using Engle and Granger, Johannes co-integration and Error
Correction model approaches. The results reveal that disposable income, real GDP growth,
population growth have a positive and significant impacts on national saving. The results also
reveal that aggregate consumption(C) has a negative and significant impact on national saving.
Furthermore, the policies mechanism towards real GDP growth rate and national disposable
should be given first priority if the national savings trend is to be enhanced over time. Moreover,
from a policy point of view the precautionary motive for saving is supported partial by the
finding result of inflation was insignificant which captures the degree of macroeconomic stability
in Ethiopia. The coefficient of the error correction model (ECM) in the short run is significant
with expected negative sign which implies that any shock diverges in the long run disequilibrium
that can converge to the long run equilibrium path by 66 percent. Which implies that around 66
percent deviations from the long run disequilibrium are adjusted every year and the rest 34
percent in the coming year

Key words: National saving, OLS and Permanent/Life-Cycle Income hypothesis

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 List of Acronyms

ADF Augmented Dickey Fuller

APS Average propensity to saving

C Aggregate consumption
Dr Deposit rate

DW Durbin Watson
ECM Error Correction Model
ECM_1 Error Correction Model in one lag
GDP Gross domestic product

H1 Alternative hypothesis
Ho Null hypothesis
INF Inflation rate proxy by Consumer price index

MoFEC Ministry of Finance and Economic Corporation

MPS Marginal propensity to saving

NBE National Bank of Ethiopia

Ns National saving

OLS Ordinary Least Squares

Pg Population growth

PIH Permanent income hypothesis

Yd National disposable income

Yr Real Gross Domestic Product

CUSUM Cumulative sum of control chart

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List of Tables
Table 1: Expectation of hypothesis---------------------------------------------------------------------12
Table 2 Descriptive Analysis-----------------------------------------------------------------------------13
Table3 Summary of Unit root test results---------------------------------------------------------------17
Table 4: Co-integration Test using Johansen-----------------------------------------------------------18
Table 5: Co-integration test using Engel Granger approach------------------------------------------18
Table 6: Long Run Regression Results-------------------------------------------------------------------19
Table7: The Long run Diagnostic Test Results----------------------------------------------------------20
Table 8: Result for Error Correction Model (ECM_1) -------------------------------------------------21

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List of Figures
Figure 1: National saving (Ns) and Real economy growth (Yr) -------------------------------------14
Figure 2 Saving (Ns) and Aggregate Consumption(C) ------------------------------------------------14
Figure 3 Saving (Ns) and Inflation (INF) ----------------------------------------------------------------15
Figure 4 Saving (Ns) and Deposit rate (Dr) -------------------------------------------------------------15
Figure 5 National saving and gross national disposable Income--------------------------------------16
Figure 6 National saving & Population growth (Pg) ---------------------------------------------------16
Figure 7: CUSUM test Heteroscedasticity---------------------------------------------------------------21

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Table of Contents Pages
Abstract----------------------------------------------------------------------------------------------i
List of Acronyms----------------------------------------------------------------------------------ii
List of Tables--------------------------------------------------------------------------------------iii
List of Figures-------------------------------------------------------------------------------------iv
List of Contents------------------------------------------------------------------------------------v
Chapter One----------------------------------------------------------------------------------------1
1. Introduction--------------------------------------------------------------------------------------1
1.1Background of the study-----------------------------------------------------------------------1
1.2 Statement of the problem----------------------------------------------------------------------2
1.3 Objective of the study--------------------------------------------------------------------------3
1.3.1 General Objective----------------------------------------------------------------------------3
1.3.2 Specific objectives---------------------------------------------------------------------------3
1.4 Significance of the study----------------------------------------------------------------------3
1.5 Scope of The study-----------------------------------------------------------------------------4
1.7Organization of the study----------------------------------------------------------------------4
Chapter Two-----------------------------------------------------------------------------------------5
2. Literature Review---------------------------------------------------------------------------------5
Forms of Saving------------------------------------------------------------------------------------5
Personal saving-------------------------------------------------------------------------------------5
Corporate saving------------------------------------------------------------------------------------5
Public saving-----------------------------------------------------------------------------------------5
Foreign saving---------------------------------------------------------------------------------------5
2.1Theoretical Review-------------------------------------------------------------------------------5
2.1.2 Theory of Absolute Income Hypothesis----------------------------------------------------5
2.1.3. Theory of Relative Income Hypothesis----------------------------------------------------6
2.1.4. Theory of Permanent Income Hypothesis-------------------------------------------------6
2.1.5 Theory of Life-Cycle Hypothesis------------------------------------------------------------7
2.1.6 The McKinnon-Shaw Hypothesis------------------------------------------------------------8
2.1.7 Rational Expectations Hypothesis (REH) --------------------------------------------------8
2.2 Empirical Review---------------------------------------------------------------------------------9

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Chapter Three-------------------------------------------------------------------------------------------11
3. Methodology-----------------------------------------------------------------------------------------11
3.1 Source of Data--------------------------------------------------------------------------------------11
3.2 Model Specification-------------------------------------------------------------------------------11
3.3 Definition of terms---------------------------------------------------------------------------------12
3.4 Expected Sign---------------------------------------------------------------------------------------12
3.5 Estimation Techniques----------------------------------------------------------------------------12
Chapter Four--------------------------------------------------------------------------------------------13
4. Empirical Results and Analysis-------------------------------------------------------------------13
4.1. Descriptive Data Analysis-----------------------------------------------------------------------14
4.2Trends of National saving with Explanatory variables---------------------------------------13
4.2Econometric Model Analysis---------------------------------------------------------------------17
4.2.1 Stationarity Test---------------------------------------------------------------------------------17
4.2.2 Co-integration Analysis------------------------------------------------------------------------18
4.3. Estimation Results--------------------------------------------------------------------------------19
4.3.1 Long Run Results--------------------------------------------------------------------------------19
4.3.2 Diagnostic Tests----------------------------------------------------------------------------------20
5.2 Error Correction Model (ECM_1) Result-------------------------------------------------------21
Chapter Five---------------------------------------------------------------------------------------------23
5. Conclusion and Recommendation ----------------------------------------------------------------23
5.1 Conclusion------------------------------------------------------------------------------------------23
5.2 Recommendation-----------------------------------------------------------------------------------24
Bibliography---------------------------------------------------------------------------------------------25

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 CHAPTER ONE
1. Introduction
1.1 Background of the study
Aggregate savings play a dominant role in the economic growth and stability of any country, as
it enhances capital development and economic growth. According to (Romer, 1986) economic
growth depends upon technological changes, human capital and Monetary and Fiscal policies
and at all macroeconomic variables. If poor countries want to increase growth rates then it is
necessary for them to save and invest higher proportion of national income (Angus S. Deaton,
Christina Paxson, 1994).
There exists extensive consent that low aggregate saving is one of the most severe obstructions
to attain higher and maintainable economic growth. Presently Ethiopia, economy is facing the
problem of macroeconomic instability. Saving decisions have both short run and long run
importance for the purpose of macroeconomic analysis. Fundamentally aggregate saving
established the quantity of capital stock and a most important source of standard of living.
According to economic point of view saving can play important role to increase employment,
GDP growth and economic stability. Furthermore saving may increase aggregate demand by
increasing the level of gross capital formation and it leads to rise to economic growth. For the
purpose of promoting economic growth and benefits of the underdeveloped countries, saving is
considered to be crucial factor.
In many sub-Saharan African countries, the rate of economic growth has been impeded by the
low level of saving mobilization making them depend on foreign assistance in form of loans and
aid to finance their current account deficit and investment costs (Epaphra, 2014). Indeed, since
the Sub-Sahara Africa, the level of saving to GDP ratio has on average 17.6, when compare to
South Asia, 29.7% and newly industrialized countries 43% in 2016 (Bank, 2016/2017) (TEDLA,
2016).
Ethiopia is the second-most populated country in Africa with more than 90 million people. It is
among the low-income sub-Sahara African countries and has been a representative of poverty for
a number of decades. The country is experiencing a severe resource gap according to Ethiopia
the contribution of aggregate saving to gross investment is indirectly the mirror image of foreign
saving required to meet investment demand. The requirement of foreign savings needed to

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finance the saving investment gap, reflects the current account deficit in the balance of payments.
Ethiopia’s continuing external deficit problem is generally viewed as a symptom of inadequate
national savings, the level of the gross domestic saving and gross national saving to GDP ratio
stood at an average of 15.5 percent and 29.1 percent from 2002/03-2015/16, during the same
period, investment to GDP ratio was 33.1percent. Despite the importance of saving for economic
growth, saving rate is lower to finance the domestic investment in most developing countries.
Therefore, net foreign resource inflows are financing the saving investment gaps in Ethiopia
(Ethiopia, National Accounting System , 2010-2011).
Theoretically, there are two ways of improving the savings investment gap. One is through
increasing savings and the other is through decreasing investment. Ethiopia needs to gear up both
savings and investment to enhance the employment generating ability of the economy as well as
increase resource availability for investment and to fill the current account deficit in the balance
of payments. Low saving rates has been identified as one of the big challenge, for growth
process, especially in developing countries like Ethiopia (Schmid et al, 1992).

1.2 Statement of the problem

Saving is naturally plays an important role in the economic growth and development process in
Ethiopia. Saving determines the national capacity to invest and thus to produce, which in turn,
affect economic growth potential of the country. Low saving rates have been cited as one of the
most serious constraints to sustainable economic growth in Ethiopia. Gross domestic and
national saving which were 9.5 and 23.1 percent of GDP in 2008/09 respectively. On the other
hand, the shares of total and gross domestic investment to GDP were 33.7 and 24.9 percent in
2008/09 and resource gap was -18.4 in Ethiopia (Ethiopia N. B., 2010-2011). The major
determinant variables of national saving(NS) in Ethiopia are real gross domestic
product(RGDP), national disposable income(Yd), aggregate consumption(C), inflation rate (INF)
it proxy by consumer price index, population growth(Pg) and deposit rate(DR) Therefore, those
variables hamper the capacity of saving growth. Empirical work by (Barro, 1990) has provided
support to the notion that saving is central for understanding growth differential across countries.
Unfortunately, for long periods low domestic saving, on the other hand, national saving in
general and private saving in particular is the developing stage in Ethiopia that affect the
economic growth (Hailu, 2016).

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There are several studies have been employed in Ethiopia on about the contribution and
relationships of saving and economic growth. The most of them were only focused on the
determinants and the impact of domestic saving on economic growth and itself, the others also
much emphasized on the relationship between national saving and economic growth. There was
no empirical investigation on the determinants of national saving in Ethiopia. It appears,
therefore, that any explanation that simply relies on domestic savings, stimulating investment
and output to achieve economic growth is, at some level incomplete. Rather, there must be other,
deeper reasons that will refer as fundamental determinants for national saving. Therefore, this
researcher will hope that this study will try to fill these gaps by providing and distinguished the
major determinants of national saving in Ethiopia. The controversy concerning the temporal
precedence between these variables is one of the most questioned issues in current
macroeconomics, as noted by (Kwakwa, 2014). Therefore, the problem of the statement of this
study is investigated the crucial factors that were responsible for the low saving in Ethiopia.
1.3 Objective of the study
1.3.1 General Objective
The main objective of this study was focused on identifying the determinants of national saving.

1.3.2 Specific objectives

In line with the above general objective, the paper will have the following specific objectives:
1. To examine the trends of National saving across different time.

2. To point out which parameters are significantly determines National saving activities in the
short and long run in Ethiopia.

3. To forward policy implications based on findings.

1.4 Significance of the study
The findings of this study are believed to provide a useful contribution to the empirical basis
needed for proper understanding of the previous routes as well as give emphasis for future
process on saving issue.
The study also adds value to the accumulation of knowledge by showing the major determinants
of national saving.

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1.5 Scope of The study
The paper would combine in study the main determinants of national saving performance and its
growth rate using econometric model and descriptive analysis with respect in Ethiopia: during
the period 1980 – 2016. The period covers only the two regimes (Dreg and EPRDF).This is
because to get recent and reliable data with possible data information.
1.6Organization of the study
The remained of the paper are structured as follows: Chapter-Two describes a literature review,
including theoretical and empirical works. Chapter Three specifies the methodology of the study.
The last two Chapters (4 & 5) are compile results and discussion; and conclusions and
recommendations respectively.

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 CHAPTER TWO
2. Literature Review
2.1Theoretical Review
There are six widely accepted theories that explain the saving behavior of economic agents and
those theories are concerning on the determinants of savings and have been examined. Below is a
review of among others; the Keynesian absolute income hypothesis (1936), Friedman’s
permanent income hypothesis (1957), the life-cycle hypothesis (1963), Duesenbery’s relative
income hypothesis (1949), the McKinnon-Shaw hypothesis; and Hall’s rational expectations
hypothesis. Government saving originates from the surplus budgeting, but very few countries
make part of their public sector saving from saving or profit of the government owned
enterprises. There are also two aspects of private domestic saving. These include corporate
savings and household savings. Again foreign savings also come into two basic forms such as
foreign aid, and private foreign savings.
Forms of Saving
Personal saving: are household savings of individuals in the economy (Miller, 2008).
Corporate saving: are businesses savings as a component of the private savings which are re-invest
by business owners, ( Janine Aron & John Muellbauer, 2000).
Public saving: are savings by the government due from increased tax or reduced spending
(Eregba & Irugbe, 2009).
Foreign saving: in a small open economy where capital is mobile, investment is not
constrained by domestic saving as firms have access to foreign saving.

2.1.2 Theory of Absolute Income Hypothesis

Keynes in his theory argues that consumption and savings are an increasing function of
absolute/disposable income. Keynes postulates that consumption will increase at a decreasing
rate as the income increases other things being constant. This implies that part of the income will
be saved at an increasing rate as the disposable income increases. Generally, the Keynesian
saving function takes a form of linear function with constant marginal propensity to save (MPS).
St = α +βYt ------------------------------------------------------------------------------------------------- (1)

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Where, St and Yt denote the real value of saving and total disposable income, respectively at time
Δ𝑆
t. β= , the marginal propensity to save is expected to be constant and positive but less
Δ𝑌
than unity, so that the higher income leads to higher saving. Moreover, Keynes postulates that as
𝑆
the level of income rises, the average propensity to save, APS = , also rises. α is constant
𝑌
with value less than zero. Hence, with Yt = 0, saving is negative or very low and in general,
income-savings relationship is not proportional. Other things being constant, the theory assumes
that rich people save more than poor people (Keynes, 1936).

2.1.3. Theory of Relative Income Hypothesis

(Duesenberry, 1949) postulates that household consumption function depends on household
income in relation to other household income, as a result, for any given relative income
distribution, the percent of income saved by a household will tend to be unique, invariant, and
increasing function of its percentile position in the income distribution. The RIH assumes that
the percent of income saved will be independent of the absolute level of income. Hence, the
aggregate saving ratio will be independent of the absolute level of income (Alimi,Alvarez-
Cuadrado and Long, 2011). This implies that the MPS of an individual would be higher if his
percentile position in the income distribution is higher. Moreover, the RIH suggest that if there is
an upward change in income of a household, it would not aspire for a similar upward change in
consumption level than the one already achieved implying that its saving rate will increase due to
increase in income. Duesenberry (1949) concludes that aggregate saving rate is independent of
aggregate income, which is consistent with the time series evidence; and the propensity to save
of an individual is an increasing function of his or her percentile position in the income
distribution.

2.1.4. Theory of Permanent Income Hypothesis

The core of Friedman’s PIH is that individuals are rational and they seek to maximize their
lifetime utility subject to the constraint that all their lifetime resources must be spent. In this
hypothesis, income and consumption are divided into two major components, the transitory and
permanent components. This is because an individual economic agent is thought to plan his
expenditures on both income received during the current period and income expected during his
lifetime. Therefore, consumers plan their expenditure on the grounds of a long-run view of the

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resources that will accrue to them in their lifetime. Friedman argues that, permanent income
should be considered when studying the saving and consumption behavior of economic agents,
not absolute income as Keynes suggests. According to Friedman’s PIH, the saving function at
time t in its simplest form given the transitory and permanent income can be expressed as

St =θ +ῼY P +ѱYT ------------------------------------------------------- (2)

Where, YP +YT, ῼ is the marginal propensity to save given permanent income (YP), ѱ is the
marginal propensity to save given transitory income (YT). Friedman hypothesizes that

individuals consume virtually no transitory income implying that ῼ =1. This shows that past

behavior will determine the consumption spending. However, changes in transitory income will
lead to changes in saving, that is, the higher the transitory income, the higher the saving rate
(Raymond F Mikesell and James E Zinser, 1973).

2.1.5 Theory of Life-Cycle Hypothesis

(Modigliani and Ando, 1963) Postulate a life-cycle hypothesis of consumption of an individual
in a specified period of time. According to this hypothesis, the individuals have an income
stream which is relatively low at the beginning and the end of their life, when their productivity
is low and high during the middle of their life (Branson, 1979). This model suggests that in the
early years of a persons’ life they are net borrowers. In the middle years, they save to repay debts
and provide for retirement. Borrowing will always attract interest rate. The life cycle model
predicts that a higher interest rate increases the current price of consumption visa- vies the future
price, thus leading to an increase in savings.
In the light of life-cycle analysis, GDP growth will result in an increase of aggregate savings,
because it increases the lifetime earnings and saving of younger age groups relative to older age
groups (Athukorala, P., & Sen, K, 2004). Thus, countries with higher GDP growth rates are
expected to have higher saving than countries with lower growth rates. However, the size of this
effect is likely to decline as GDP growth raises and May even become negative for rich countries
where investment opportunities and growth are relatively lower (Masson et al, 1998). In another
aspect, although, the life cycle model suggests that inflation does not have a real impact on
saving behavior because of the absence of money illusion, macroeconomic instability in the form
of inflation is likely to rise saving since risk-averse consumers tend to save more as a precaution
against possible adverse changes in future income (Edwards, Loayza et al , 2010). In that case,

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households will reduce their present consumption and save more in order to consume more in
future. In the same vein, inflation acts as a tax on money balance holdings, so if households wish
to maintain the real value of their money balance holdings, saving will rise with the rate of
inflation.
The life cycle model of saving analyzed the patterns of individual consumption and predicted
that the consumption of individuals depends on the expectation of the long term earnings
(income) and saving patterns, to level out the consumption over the long period of time. As
individual income tends to fluctuate over the period of individual life, savings is determined by a
period of individual life in which they save more than the disposable income. Thus individuals in
their life time first act as savers during high income times (while working) and act as dissever in
low income time (during retirement), therefore individuals smooth out future consumption by
using current earnings.

2.1.6 The McKinnon-Shaw Hypothesis

(Ronald McKinnon , and Edward Shaw, 1973, 1973) Argue that the rate of return on saving, as
measured by real interest rate, would have a positive effect on saving rates. The ability to save
represents an inter-temporal choice between present and future levels of consumption and so
high interest rates encourage economic agents to postpone present consumption in order to yield
future interest from the savings. On the other hand, high interest rates encourage economic
participants to reduce saving levels since they expect to get substantial yield even if they save
less. They also explain the role of government in mobilizing saving through the financial
repression hypothesis. Governments over the years have deliberately kept interest rates below
market clearing levels to promote investment. McKinnon observes that with controlled interest
rates it is likely that not all economic agents will access credit and this can lead to dualism,
where those firms can access subsidized credit would employ capital-intensive technologies and
those not favored by the policy’ would only carry out high-yielding projects with a short
maturity.

2.1.7 Rational Expectations Hypothesis (REH)

(Jonathan A. Parker, Hal, 1999,1978), Estimated the consumption function based on
expectations. The consumption function estimated thus used the weak efficiency assumptions,
that is, the belief that past values can be used to explain the present values. In this way, Hall
construed that past consumption values are enough explanation on current consumption behavior

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assuming that consumers are rational. The REH assumes that economic agents keep track of their
consumption patterns. Consumption (C) decision at any time, say t, takes into account of known
information and expectations of the consumer about the future flow of income as of time t
(Branson, 1989). Using Hall’s reasoning the inter-temporal consumption model taking into
account the role of expectations can be expressed as
1+𝑟
Ct +1 = ( ) 𝐶𝑡 + Ɛ𝑡 -------------------------------------- (3)
1+ 𝜃
Where Ct +l is total consumption, r is the discount rate, θ is the rate of time preference, and Ɛt. is
transitory consumption. In regression analysis, the bracket is the coefficient of lagged values of
consumption, equation (3) above shows that consumption is a random walk. According to this
version, changes in consumption arise from surprise changes in income. In each period, the
expected next period consumption equals current consumption. Changes in consumption are
unpredictable (Romer, 2001). From this result, Hall argues that the life-cycle/permanent income
hypothesis means that consumption/saving follows a random walk.

2.2 Empirical Review

(Financial depth, savings and economic growth in Kenya: A dynamic causal linkage, 20008),
investigates the determinants of private savings for Turkey during the 1968-1994 periods. The
study reveals that income level has a positive effect on the private savings; however, the growth
rate of income is not statistically significant. The results also suggest that the rate of life
expectancy tends to have a negative impact on savings. With regard to inflation which captures
the degree of macroeconomic uncertainty, results suggest that inflation has a positive effect on
private saving.
(TEDLA, Determinants of Gross Domestic Saving: An Empirical Evidence From east Africa,
2016), examined time series analysis of the determinants of gross national saving in Ethiopia
using autoregressive distributed lag and error correction econometric modeling, and employ data
for the period 1971-2011. He revealed that financial development and Current account deficit are
significant determinants of gross national saving in Ethiopia in the long run, while the rest of the
explanatory variables such as gross national disposable income, dependency ratio, budget
deficit, and inflation, approximated by consumer price index, were reported as they are
statistically insignificant determinants of gross national saving in Ethiopia over the long run. He
also showed that variables such as gross national disposable income, financial development,

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current account deficit, and budget deficit were statistically significant in determining gross
national saving in the short run, while consumer price index and dependency ratio are not.
(Stephen Egoro A. & Obah Daddy Obah, 2015), noted that higher level of national saving leads to
higher investment and consequently higher output. This is so because the level of savings
determines the magnitude of capital accumulation. On the other hand, the magnitude of total
earnings depends on the level of total output, thus output also determines the level of savings
(capital accumulation) and investments by households and business. (al., 1995), reveal that, a
stable macroeconomic environment is important to stimulating saving. However, they point out
that the rates of saving are enhanced in an environment where the budget deficits and the rate of
inflation are low. Macroeconomic uncertainty, as measured by standard deviation of inflation has
negative influence on saving.
(Escobar & Andres, 1998), found results were in the favor of permanent income hypothesis by
suggesting that national savings respond to the changes in output. They further concluded that
high government spending leads to the decline rate of national savings; national saving is
perfectly correlated with changes in investments; national saving granger causes growth; private
saving significantly declines with urbanization and age dependency; and finally they argued that
the recent decline in private saving is mainly because of higher taxation rates.
(AHMAD, 2015), investigated the determinants of saving by using the co-integration test. Larbi
(2013) concluded that per-capita income, financial liberalization, fiscal deficit and inflation have
positive impact on the saving rate in Ghana. The results confirmed the applicability of the Ricardian
Equivalence hypothesis in Ghana. Larbi (2013) argued that government spending, improved saving
packages and control over fiscal deficit can improve the saving rate in Ghana.
(AHMAD, Determinants of Savings Behavior in Pakistan: Long Term- Short Term Association
and Causality, 2015), investigated the savings behavior in Pakistan by dividing the data into rural
and urban data and by using the OLS. They suggested that savings in Pakistan is influenced by
wealth, education, current employment status, age and dependency ratio, whereas household
income also plays a very important role in the savings behavior. They also investigated that the
household savings behavior of in Pakistan by using time series data for the period of 1972 to
2003 and employed the Johansen-Juselius co-integration technique. They concluded that growth
rate; disposable income and deposit rate has significant positive impact on household saving,
whereas dependency ratio and inflation have significant negative influence on household saving.

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 CHAPTER THREE
3. Methodology
The conceptual framework for this paper is derived from Life-Cycle model. The general life-
cycle framework cannot include every variable affecting consumption and saving decisions.
Therefore, the theoretical framework adopted in this paper is rooted in the life-cycle/permanent-
income hypothesis developed by Hall (1978). This theory, also known as the random-walk
hypothesis, combines the lifecycle/permanent income variables. The theory assumes that an
individual is rational and aiming at maximizing the present value of lifetime utility subject to the
budget constraint. The budget constraint equals the current income plus the present value of
expected income in life time. Given that income fluctuates over the course of life of an
individual, each stage in the life cycle is an important determinant of saving behavior (Kudaisi,
2013). The basic idea of the lifecycle/ permanent-income hypothesis is that saving is a future
consumption, and therefore, anything that affect consumption will similarly determine saving.
This theoretical model is modified to capture a number of variables that determine saving in
Ethiopia. It is assumed that any variable that affect consumption and both current and future
income will have an impact on saving function.
3.1 Source of Data
Data were employed in this study are annual time series covering 1980-2016, the main reason to
be selected this time period was availability of all mandatory data and they are generated from
National Bank of Ethiopia and Ministry of Finance and Economic Corporation(MoFEC).
3.2 Model Specification
In explaining the determinants of the national saving models, the previous theories and empirical
studies were reviewed. Researcher used Ordinary Least Square (OLS) method to investigate the
relationship between saving behavior and its determinants. In order to determine the impact of
these variables on the national saving, the single linear regression equation is explicitly specified
in functional form as follows:
Ns = f (Yd, Yr, INF, Dr, M2, GCF, Pg) ---------------------------------------------------------- (4)
All variables are taken in the form of natural logarithm in the model below:
LnNS = βo + β1lnYr + β2lnYd + β3lnINF + β4lnDr + β5lnM2 + β6lnGCF + β7lnPg + Ut---- (5)

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3.3 Definition of terms
NS = National saving
Yr = Real gross domestic product
Yd = Disposable income
INF= Inflation proxy by consumer price index
Ca = Aggregate consumption
Dr = Deposit rate
Pg = Population growth
βo – β7 are coefficient parameters
Ln and Ut are natural logarithm and disturbance term with respectively.
3.4Expected Sign
Table 1: Expectation of hypothesis
Variables Expected sign Finding
LnCPI - -
LnYr + +
LnYd + +
LnPG - +
LnDr - -
LnC - -

3.5 Estimation Techniques

In order to avoid the problem of spurious regression results which may emanate from estimation
of non stationary macroeconomic time series, Augmented Dickey Fuller (ADF)(1979 and 1981)
test are used to check for a unit root for all variables in both levels and first differences.
Furthermore, test for the presence of co-integration, the Johansen (1991) test is employed. This is
the powerful method particularly when the multivariate model is involved.
The ordinary least squares method (OLS) is used for estimation. OLS is simple and widely used
in empirical work. If the model’s error term is normally, independently and identically
distributed (n.i.i.d.), OLS yields the most efficient unbiased estimators for the model’s
coefficients, i.e. no other technique can produce unbiased slope parameter estimators with lower
standard errors (Ramirez et al., 2002). Furthermore, to check short and the long run impacts
error correction model (ECM) has been employed in the model.

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 CHAPTER FOUR
4. Empirical Results and Analysis
4.1. Descriptive Data Analysis
Table 2 Descriptive Analysis
LNNS LNPG LNYD LNYR LNDR LNCPI LNC
Mean 64345.42 11.08620 247705.7 206740.2 5.324324 39.79456 12.13710
Median 13089.77 11.21072 58344.95 52388.40 5.000000 23.10741 11.92522
Maximum 494999.0 11.43961 1681113. 1409454. 10.00000 154.7720 13.34957
Minimum 1689.340 8.813141 12260.02 11618.09 3.000000 8.699948 11.44858
Std. Dev. 120572.2 0.439035 422557.0 352499.4 2.000751 41.38866 0.612244
Skewness 2.309771 -3.869223 2.125963 2.158117 1.127014 1.613640 0.637660
Kurtosis 7.404528 20.63271 6.503271 6.640992 3.785718 4.275160 2.041324
Jarque-Bera 62.80756 571.6440 46.79234 49.15867 8.784413 18.56377 3.924314
Probability 0.000000 0.000000 0.000000 0.000000 0.012373 0.000093 0.040555
Observations 37 37 37 37 37 37 37
Source: Source: Own Computation
Descriptive analysis is conducted to ascertain the statistical properties of the variables. Table 1
presents descriptive statistics of the variables of the estimation model. The descriptive statistics
suggest that all exogenous and endogenous variables in the model are normally distributed
because their respective P -Value is less than 0.5.
4.2Trends of National saving with Explanatory variables
Saving is the most important factor that has contributed to the economic growth and significantly
enabled the capacity of economy in Ethiopia. Hence, it is important to observe the saving
performance with its determinants that are as follows:

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Figure 1: National saving (Ns) and Real GDP (Yr)
16.00
14.00
Both variables are taken as

12.00
10.00
natural log

8.00 Yr
6.00
Ns
4.00
2.00
0.00

2004
1980
1983
1986
1989
1992
1995
1998
2001

2007
2010
2013
2016
Source: Constructed Using Data from NBE.
As figure 1 reveals that from 1980-2016, throughout studying period real gross domestic product
(Yr) was higher than saving (Ns) and both variables are taken in real value; however, saving is
going to the parallel ways with economic growth. In line with light of life-cycle analysis, GDP
growth will result in an increase of aggregate savings, because it increases the lifetime earnings
and saving of younger age groups relative to older age groups (Athukorala, P., & Sen, K, 2004).
Thus, countries with higher GDP growth are expected to have higher saving than countries with
lower growth.
Figure 2 Saving (Ns) and Consumption(C)

700,000
600,000
500,000
In millions

400,000
National saving(Ns)
300,000
Consumption(C)
200,000
100,000
-
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016

Source: Constructed Using Data from NBE.

As figure 2 reveals that from 1980-2002, in this period consumption expenditure(C) was above
saving (Ns) and saving almost was at zero level but positive. However, the path of saving is

14 | P a g e
started to upward trend from 2003 to the study period but it still below; this may be due to
economic expansion that started growth by double digit in 2004.
Figure3 Saving (Ns) and Inflation (INF)
60.0
INF(Consumer price index)

50.0
NS(Logarithm)

40.0

30.0 NS
INF
20.0

10.0

-
1988

2016
1980
1982
1984
1986

1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Source: Constructed Using Data from NBE.
Inflation rate showed fluctuated up and down trend throughout the study period except the year
of 1991, 2008 and 2011, in these three different years the inflation rate shows highly upward
trends where as it started to decline from 2012 when compared with National saving trend. This
reduction of inflation rate reflects the macroeconomic stabilization and sustains economic
growth in Ethiopia and therefore, saving improved during that period (2012-2016).
Figure 4 Saving (Ns) and Deposit rate (Dr)
15.0
Saving(Natural Logarithm)
IDeposit rate(Percentage)

10.0

5.0
NS
Dr
-
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
2016

Source: Constructed Using Data from NBE.

Overall trends of deposit rate shows up and down trend throughout the study period, however,
national saving trend with saving deposit rate shows the upward trend. Due to this the

15 | P a g e
macroeconomic stabilization and sustain economic growth in Ethiopia. This situation might have
led to high savings.
Figure 5National saving and Disposable Income

National saving and national disposable income

1800000
1600000
1400000
Birr in millions

1200000
1000000 NS
800000
600000 Yd
400000
200000
0

2016
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Source: Constructed Using Data from NBE.
Income received by economic agents, particularly households can be disposed of in three ways:
it can be paid in tax, consumed or saved. Income after tax is disposable income. In Keynes, since
consumption is a function of disposable income, and saving is income not spent, saving is also
primarily a function of disposable income. Disposable income has been taken to be the main, but
not the only, determinant of saving. Fig4 shows a positive correlation between saving and
disposable income in Ethiopia because of this, trend of both variables are going to upward.
Figure 6 National saving & Population growth (Pg)

National saving and Population(Pg)

600000
500000
In millions

400000
300000 NS
200000 Pg
100000
0
1986

2012
1980
1982
1984

1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010

2014
2016

Source: Constructed Using Data from NBE and CSA.

16 | P a g e
In another aspect, one of the most celebrated predictions of the life cycle theory of saving is that
the national saving-to-national income ratio depends positively on the rate of population growth.
People save for retirement, so saving is positive for young and negative for the old. Increase in
population growth favors saving over dissaving Fig 5. But the population graph was broken
during a year of 1994(in our case 1987), this may due to political regime rather than data
variability

4.2Econometric Model Analysis

4.2.1 Stationarity Test
A basic assumption of the Classical Linear Regression model requires all variables to be
stationary. The violation of this assumption leads to spurious regression. To avoid this shortfall,
the unit root test with and without trend is conducted on all variables to find out whether they are
stationary or non-stationary. The Augmented Dickey-Fuller (ADF) method is conducted to check
for a unit root for all variables in both level’s and first difference.
Table3 Summary of Unit root test results
Variable ADF T- Value at Level Stationarity ADF T- Value at 1st D Stationarity
Without Trend With Trend Without trend With trend

LnNs 0.827 -1.768 non-stationary -7.332 -7.748 Stationary

LnC 2.326 -1.482 """ -5.832 -7.367 """
LnInf 1.101 -1.061 """ -4.814 -5.004 """
LnDr -1.985 -1.995 """ -5.571 -5.496 """
LnYd 2.301 -0.516 """ -3.595 -4.800 """
LnYr 2.273 -0.603 """ -3.455 -4.598 """
PG -1.636 -5.551* stationary -9.921 -9.770 """
C –V (1%) -3.699 -4.243 -3.633 -4.243
C –V (5%) -2.948 -3.450 -2.948 -3.544
Source: Own Computation
Note: *indicates variable is stationary with trend at the level.
The results of these tests are presented in Table (3), which indicates that the hypothesis of a unit
root cannot be rejected in all variables at the levels except PG; it was rejected with trend but not
without trend. Therefore, concluded that LnNS, LnYd, LnC, LnInf, LnYr, and LnDr, are non-

17 | P a g e
stationary at their levels. However, the null hypothesis of a unit root is rejected in first
differences (D1st) which indicates that all variables are integrated of degree one I (1) (Table 3).
4.2.2 Co-integration Analysis
Having established that the variables are of the same order of integration in the first difference,
the next procedure is to test the possibility of co-integration among the variables used in the
model. Trace and Maximum Eigen value are used to determine the presence of co-integration
between variables. The results of the co-integration test are presented in the Table 4 below.
Table 4: Co-integration Test using Johansen
Maximum Rank (r) Eigen Value Trace Statistic 5% Critical Value
0 0.912787 237.2097 125.6154
1 0.840946 154.2699 95.75366
2 0.753335 91.76059* 69.81889*
3 0.426402 44.16992 47.85613
4 0.322220 25.27183 29.79707
5 0.284743 12.04811 15.49471
6 0.019059 0.654253 3.841466

Source: Own computation

On the basis of the maximum Eigen value test, the null hypothesis of no co-integration r = 0 is
rejected at the 5 percent level of significance in favor of the specific alternative, namely that
there is at most two co-integrating vector r = 2. Therefore, this is because the first significant
value, where trace statistic is less than critical value at 5% level, was found at maximum rank of
two. The implication is that a linear combination of all the six series is found to be stationary and
that there is a stable long-run relationship between the series.
Table 5: Co-integration test using Engel Granger approach
Critical Value P-V at level
Residual T-Value 1% 5%
ECM -4.827 -3.632 -2.948 0.0004

Source: Own computation

Table 5 is proofed that the existence of co- integration among variables that based on the ECM
has to be integrated at level I (0). Accordingly the table displays that the model had a long run
relationship between variables.

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 4.3. Estimation Result
4.3.1 Long Run Results
Table 6: Long Run Regression Result
Variable Coefficient Std. Error t-Statistic Prob.

LnPG 0.202 0.076 2.626 0.013*

LnYd 0.599 0.304 1.964 0.059**
LnYr 0.286 0.350 2.125 0.042*
LnDr 0.194 0.080 0.816 0.421
LnCPI -0.125 0.699 -1.542 0.133
LnC -0.138 0.042 -3.291 0.002***
C 13.230 0.388 2.455 0.020

R-squared 0.98 Akaike info criterion 20.280

Adjusted R-squared 0.96 Schwarz criterion 20.588
F-statistic 503.398 Hannan-Quinn criter. 20.387
Prob(F-statistic) 0.000000 Durbin-Watson stat 1.952
Source: Own computation
Notes: * significant at 5 percent; ***Significant at1 percent; **Significant at 10percent
Estimation results presented in Table 6 indicates that the F-statistic of 503.398 rejects the null
hypothesis that all the explanatory variables have, coefficients not different from zero. The data
also shows minimal impact of autocorrelation since the Durbin-Watson statistic (DW) of 1.95 is
close to 2. Moreover, adjusted R-squared is 96 percent, which measures the goodness of fit of the
variables, is sufficiently large; suggesting that about 96 percent of the variations in saving
behavior is explained by the explanatory variables. Results for saving function indicate that the
real growth of economy (Yr) has a positive effect on saving as expected and statistically
significant at 5 percent level. Other factors being constant, a 1 percent increase in GDP may lead
to 0.29 percent increase in national saving. This supports the argument that, for countries in the
initial stages of development like Ethiopia, the level of economy growth is an important
determinant of the capacity to save. Similarly, the coefficient of the level of disposable income
(Yd) is positive and statistically significant at 10 percent. The magnitude of its coefficient is
0.599, indicating that a 1 percent increase in national disposable income will have a 0.6 percent
increase in the national saving.

19 | P a g e
Contrary to expectations, the coefficient of population growth is found to be positive and
statistically significant as hypothesized; implying that, other things being constant, 1 percent
increase in population will increase saving by 0.2 percent. The coefficients of consumption
expenditure and inflation rate are found to be negative as expected in the hypothesis,
respectively. Results suggest that, inflation is insignificant, but consumption expenditure is
significant at 1 percent level with the coefficient of -0.138, which implies that 1 percent increase
in consumption will lead to about 0.14 percent decrease in national saving. This negative effect
implies that aggregate consumption greater than national savings; this is also supported by
Friedman permanent income hypothesizes that individuals consume virtually no transitory
income. However, changes in transitory income will lead to changes in saving, that is, the higher
the transitory income, the higher the saving rate (Raymond F Mikesell and James E Zinser,
1973). The negative impact of inflation rate do not provide support of precautionary motives for
saving in the face of increased uncertainty in Ethiopia; because in the another aspect, this result
proof that the life cycle model assumption. It suggests that inflation does not have a real impact
on saving behavior because of the absence of money illusion, macroeconomic instability in the
form of inflation is likely to rise saving since risk-averse consumers tend to save more as a
precaution against possible adverse changes in future income (Edwards, Loayza et al , 2010), so
that the effect of inflation is statistically weak. The coefficient of nominal deposit rate is contrary
to expectations and also statistically insignificant. Thus, there is no empirical evidence that
supports the influence of interest rate liberalization on national saving in Ethiopia. In general
implication drawn from this result is that deposit rate would not bring about automatic
improvement in national saving when policies are formulated basing on these variable.
4.3.2 Diagnostic Tests
Table7: The Long run Diagnostic Test Results
Test Statistic Test Test value P -Value
BGS.LM F- statistic 0.763 0.475
BG .HT F- statistic 4.831361 0.4975
Ramsey Reset stability T- Statistic 1.434948 0.1620
Test F –Statistic 2.059075 0.1620
Likelihood ratio 3.538022 0.1111
Normality Jarque-Bera 1.750144 0.4163
Source: own computation

20 | P a g e
The above table reported the diagnostic tests of long run National Saving. The results imply that
the residuals are normal distributed as an indicated by Jarque-Bera test indication. The serial
correlation LM test also shows that residuals free from serial correlation problems in the test.
The Ramsey RESET stability test has been involved if so there was no model specification
problem in the model. Finally, Heteroscedasticity test has been checked in the model, therefore,
residuals are homoskedastic. In addition to this, the CUSUM test has been taken to check
Heteroscedasticity problem; the test results indicated that the residual is statistically significant at
5 percent and it lie between in the red lines as follows.
Figure 7: CUSUM test Heteroscedasticity
16

12

-4

-8

-12

-16
88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

CUSUM 5% Significance

4.4 Error Correction Model (ECM) Result

The advantageous of this model ECM determining the National saving growth lie in its ability to
capture the short-run dynamic characteristics of saving behavior given the long run co-
integration (equilibrium) relationship.
Table 8: Result for Error Correction Model (ECM_1) and diagnostic tests
Variable Coefficient Std. t-Statistic Prob.
Error
DLNC -0.024614 0.1413 -0.1741 0.8630
DLNCPI -0.8194 0.2553 1.6453 0.1107
DLNYD_1 2.196267 0.8275 2.6537 0.0128
DLNYR_1 -2.231992 0.9459 -2.3594 0.0252
ECM_1 -0.6601 0.6263 -2.5096 0.0179
C -2007.154 0.2619 -0.7662 0.4497
R-squared 0.83 Akaike info criterion 21.7267

21 | P a g e
Adjusted R- 0.81 Schwarz criterion 21.9933
squared
Log likelihood -374.2177 Hannan-Quinn criter. 21.8187
F-statistic 30.4335 Durbin-Watson stat 1.6961
Prob(F-statistic) 0.00000
Statistic Test Test value P-value
BGS.LM F- statistic 28.36804 0.78602
BG. HT F- statistic 7.023492 0.56021
RRS.test T- statistic 1.020457 0.3159
F- statistic 1.041332 0.3159
Li-- ratio 1.270021 0.2598

Normality Jarque-Bera 14.0009 0.90726

Source: Own computation

The coefficient of the error correction model (ECM) in the short run is significant with expected
negative sign which implies that any shock diverges in the long run disequilibrium that can
converge to the long run equilibrium path. What results concluded that the goodness of the
model is good in that adjusted R square was 0.81 percent in the table 8. Therefore, the speed of
adjustment is 66 percent which implies that around 66 percent deviations from the long run
disequilibrium are adjusted every year and the rest 34 percent in the coming year. Furthermore,
F-statistic is significant with a probability of 0.0000 which implies that the model was fitted. The
results of various diagnostic tests such as Breush-Pagan-Godfrey test for heteroscedasticity,
Breush-Godfrey LM Test for serial correlation, Jarque-Bera test for normality, and Ramsey's
general test of model misspecification which are discussed and all tests did not detect any
problem of serial correlation (Auto-correlation), heteroscedasticity, Non-normality and model
misspecification as well.

22 | P a g e
 CHAPTER FIVE
5. Conclusion and Recommendation
5.1 Conclusion
This paper empirically examined the determinants and trends of national saving in Ethiopia for
the 1980-2016 periods. This study was carried out using Ordinary Least Square (OLS) method to
estimate the regression line and together, this time series econometrics method and descriptive
analysis was employed to identify determinants of national saving performance. Several studies
have been employed in Ethiopia on about the contribution and relationships of saving and
economic growth. Most of them were only focused on the determinants and the impact of
domestic saving on economic growth; the others also much emphasized on the relationship
between national saving and economic growth. There was no empirical investigation on the
determinants of national saving in Ethiopia. The results of this paper help to understand the
effectiveness of policy variables in rising the national saving in terms of their magnitude and
direction. Augmented Dickey Fuller test was used to test stationarity of all time series. To test
the short and long run relationship of the variables within co-integration, Johansen and Engle-
Granger tests were applied. The results of the paper provide evidence that national saving in
Ethiopia is determined by a number of factors. First, Disposable income, GDP growth rate,
aggregate consumption, and population growth were crucial. The trend of national saving
during the study period; descriptive analyze reveals that all variables was going as well started
from recent years in Ethiopia except aggregate consumption and deposit rate. Form the point of
deposit rate, saving has show upward, and this upward trend dose not indicated the capacity of
saving deposit rate but it come from recent economy growth. The long run estimation findings
are real economy growth (Yr), national disposable income (Yd) and population growth (Pg) has
positive and significant impacts on national saving. Inflation rate was negative and deposit rate
was positive but both are statistically insignificant. Second, the precautionary motive for saving
is supported by the finding and partial, as an inflation which captures the degree of
macroeconomic stability. It does mean if it has a negative impact but effect was insignificant on
national saving in Ethiopia. Third, population growth rate have positive and statistically
significant impact on saving, supporting to the life-cycle hypothesis. The life-cycle hypothesis
suggests that population aging will initially lead to an increase in national saving as the

23 | P a g e
proportion of the population in the maximum saving years increases, but contrary with
expectation. Fourthly, aggregate consumption(C) has negative and significant impact on national
saving. This negative effect implies that aggregate consumption greater than national savings, it
represents dissaving. This is also supported by Friedman permanent income hypothesizes that
individuals consume virtually no transitory income. This shows that past behavior will determine
the consumption spending. However, changes in transitory income will lead to changes in
saving, that is, the higher the transitory income, the higher the saving rate. The coefficient of the
error correction model (ECM_1) in the short run is significant with expected negative sign which
implies that any shock diverges in the long run disequilibrium that can converge to the long run
equilibrium path within a year.
5.2 Recommendation
Some major recommendations for policy can be drawn from the analysis. Policies mechanism
towards:
 The economic policies should have focused on multidimensional improvement in
economic growth and gross national disposable income that may improve saving rates.
That can be achieved by improving the economic base by focusing on key sectors such as
agriculture in which a large part of labour force is involved.
 The aggregate consumption of the country has a negative impact on national saving; it
indicates country’s consumption behavior is higher than saving. So that it leads to have
adverse effect in the long term economy growth; therefore, the policy should emphasis by
creating conducive opportunities for citizens. Like, by sustain and expend that operated
and upcoming industrial parks and attracting new international investment opportunities
that may increased earning capacity of the citizens and create transitory income as well as
improved saving level.
 The policies should develop the saving habit of the citizens by creating awareness and
importance of saving, increasing job opportunities and skilled man powers in the country.
 Monetary policy should have work on the deposit rates to stimulate saving and
investment motives in the economy.

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