Chapter 1

1Introduction

1.1 background of the study

Saving is the individual preference for future consumption over present consumption. Savings
refers to the money that a person has left over after they subtract out their consumer
spending from their disposal income over a given time period. Savings, therefore, represents a
net surplus of funds for an individual or household after all expenses and obligations have been
paid. Savings accounts are very safe but tend to offer very low rates of return as a result.
Saving may take the form of increases in bank deposits, purchases of securities, or
increased cash holdings. The extent to which individuals save is affected by their preferences for
future over present c0nsumption, their expectations of future income, and to some extent by the
rate of interest.

Total national saving is measured as the excess of national income over consumption and taxes
and is the same as national investment, or the excess of net national product over the parts of the
product made up of consumption goods and services and items bought by government
expenditures. Thus, in national income accounts, saving is always equal to investment. An
alternative measure of saving is the estimated change in total net worth over a period of time.
Saving is important to the economic progress of a country because of its relation to investment.
If there is to be an increase in productive wealth, some individuals must be willing
to abstain from consuming their entire income. Progress is not dependent on saving alone; there
must also be individuals willing to invest and thereby increase productive capacity.

The interest rate is the amount a lender charges a borrower and is a percentage of the principal
—the amount loaned. The interest rate on a loan is typically noted on an annual basis known as
the annual percentage rate. An interest rate also applies to the amount earned at a bank or credit
union from a deposit account. The total interest on an amount lent or borrowed depends on the
principal sum, the interest rate, the compounding frequency, and the length of time over which it
is lent, deposited, or borrowed. A borrower that is considered low risk by the lender will have a
lower interest rate. A loan that is considered high risk will have a higher interest rate.
Individuals borrow money to purchase homes, fund projects, launch or fund businesses, or pay
for college tuition. Businesses take out loans to fund capital projects and expand their
operations by purchasing fixed and long-term assets such as land, buildings, and machinery.
Borrowed money is repaid either in a lump sum by a pre-determined date or in periodic
installments.

Individuals, banks, corporations, municipalities, and credit card companies are all types of
lenders.

In addition to interest rate, income level, and income distribution, consumption motivations and
habits affect saving

Since the future cannot be surely known, what we do today whether affect directly or indirectly
what we live tomorrow. Emergencies will arise without giving as signs to make our
comprehensive decisions. So financial emergencies and unexpected expenses are two of the
major factors that make saving important. Saving money can help us to reduce financial stress in
the future, to avoid unnecessary debt, and to pay for big purchases. Long-term security at the age
when we cannot do works, paying for college education, able to afford big life events like
marriage, able to reach financial independence, taking advantage of the interest, helping others
when they need of money to invest are the reasons that make saving really important.

Saving in the financial institutions has an advantage of revenue in the form of interest on saved
principal. The need for saving in saving institutions is to grant loans for borrowers, in which they
can make the larger interest on the borrowed money the difference between interest income and
interest expense makes them profitable.

Interest rates determine the amount of interest payments that savers will receive on
their deposits. An increase in interest rates will make saving more attractive and
should encourage saving. A cut in interest rates will reduce the rewards of saving and
will tend to discourage saving Lower interest rates weaken the motivation to save
because the returns from lowered interest payments are often weaker. When interest rates
are low, there is a stronger incentive to spend than to keep saving.
Background of national Bank of Ethiopia

began operation in January 1964. Prior to this proclamation, the Bank used to carry out dual
activities, i.e. commercial banking and central banking. The proclamation raised the Bank’s
capital to Ethiopian dollars 10.0 million and granted broad administrative autonomy and juridical
personality. Following the proclamation the National Bank of Ethiopia was entrusted with the
following responsibilities.

• To regulate the supply, availability and cost of money and credit

• To manage and administer the country’s international reserves.

• To license & supervise banks & hold commercial banks reserves & lend money to them.

• To supervise loans of commercial banks and regulate interest rates.

• To issue paper money and coins.

• To act as an agent of the Government

• To fix and control the foreign exchange ratesp

This study devoted to the assessment of the direction and extent to which interest rate affects
domestic saving in Ethiopia.

Prior to the early 1970s maintaining low level of interest rate was believed be the best interest
rate policy in most developing countries. I.e. financial repression policy. It was believed that
interest rate should be kept at lower level so that saving will be encouraged Lower rate of interest
rate increase investment by making their cost of finance above their expected rate of return
(Ghatak, 1981]. How ever, in early 1970s there is change of attitude in interest rate policy with
emergency of what is known as Mckinnon-Show paradigm.

Both mekinnon 1973 shaw 1973 as cited in Turbelboom 1991 argued that if economic growth is
to be realized, financial sector should be liberalized. Liberalizing financial sector implies
abolition of all direct control on interst rate and credit. If interest rate is to be literalized it would
have as market price and will be positive in real terms enhancing saving and investment.

After Mckinnon (1973) and (1973) as cited in Turbelboom 1991 for warded their argument for
financial sector liberalization, some developing countries under took the liberalization program
during late 1970 and early 1980's.

Chapter 2

2 literature review

2.1 Theoretical literature review

2.1.1 definition and concept of saving

Saving is defined as that part of disposable income which is not spent on consumption
According to Virani (2012) saving is scarifying the current consumption in order to increase the
living standard and fulfilling the daily requirements in future. Saving is an amount of something
such as time or money that you do not need to use or spend. It could be used for investment to
earn interest (profit) or be used to purchase assets such as buildings. Saving is related to
deferring consumption, which is done by the households (individuals), the firms and, the
governments. When the interest rate is high, the household will save more money in the bank
where entrepreneurs can borrow.

A country's national savings refers to the total savings made by the private and public sectors,
including individual savings. Individual savings will benefit the households and the country
since individual savings are part of the national savings. Individual saving refers to an
individual's remaining amount of disposable income after deducting the consumption
expenditures. Since saving is a source of capital, a primary element of the production and one
that drives labor productivity and growth, thus knowing individual savings is critical to
understanding long-run economic development (Bodenhorn, 2018)

2.1.2 the concept of saving habit

Habit has been viewed differently by various scholars. Habit is a regularly repeated behavior
pattern: an action or pattern of behavior that is repeated so often that it becomes typical of
somebody, although he or she may be unaware of it. habit as anything a person or animal does,
feels, thinks or experiences
Savings habit is a crucial need for individuals to obtain and practice in order to solve their future
spending decisions. Saving and knowing how to spend wisely help individuals acquire control
over their spending patterns. Individuals who conserve money during complacent and
challenging times have a better chance of surviving in the future.
The habit of saving money requires more force of character than most people have developed,
for the reason that saving means self –denial and sacrifice of amusement and pleasures in scores
of different ways. For this very reason, one who develops the saving habit acquires at the
same time, many of the other needed characteristics which lead to success: especially self-
control, self-confidence, courage, poise and freedom from
fear

2,1.3The impact saving on economic growth

Saving is one of the important variables for economic development that has emerged as the
central issue in developing countries at least for two reasons. First, foreign aid inflow to the
developing economies has declined during recent years. Second, saving positively affects the
growth and development. The greater is the saving rate, the higher is the growth rate a country
can attain. For economic development, growth is a must which cannot be achieved without
investment or capital accumulation and saving through investment plays a vital role in this
process.

Countries with higher rates of savings have had a faster economic growth than those with lower
saving rates. Capital accumulation creates greater opportunities for production and the
productivity of a country by providing an additional income stream for countries like Ethiopia. In
that regard, the United Nations Conference on Trade and Development “Development and
Globalization: Facts and Figures (2004) emphasizes that the main factor in increasing in-country
capital is the increase of savings and that, in that regard, developing countries should prioritize
programs that promote domestic savings, in order for capital to be invested towards the most
productive practices

Although investments can be financed by external capital inflow, it involves huge uncertainty,
politically humiliating terms and economically unfavorable conditions. Apart from this, the
amount of such assistances is very much negligible in relation to our need. So, it will be
beneficial to achieve the ability to move in the direction of increasing self-reliance in terms of
financing investment or capital formation. It is the savings, which plays a dominant role in
achieving self-reliance and then growth and stability. It can help a developing economy like
Bangladesh to get rid of the so-called low-level equilibrium trap or vicious cycle of poverty by
creating a big push.

2.1.4 saving and investment

Investment is one of the important macroeconomic variables. Its fluctuations are subjected to the
amount of volatility of output and income and most economists link high rates of investment to
long run economic growth. Many researchers in their work have attempted to investigate the
theoretical and empirical relationship between investment and saving. Theoretically, classical
land neoclassical economists explain that the interest of the capital market is determined
according to investment and saving. In line with this , Goldsmith (1969), McKinnon (1973), and
Gurley and Shaw (1955),states that economic development creates demand for particular types
of financial arrangements, and the financial system responds automatically to these demands.
According to these researchers the financial system of a country mobilizes saving and improves
the allocation of saving to investment.

Accordingly, policies that promoted saving would impact favorably on growth. The traditional
view is that the level of domestic saving determines the domestic investment. Indeed, the level of
saving determines the interest rate and thus the cost of investment, which in turn influences the
demand for new capital. In this sense, low investment rate is related to low saving rate. The
positive relationship between domestic saving and domestic investment is often viewed as
evidence of imperfect international capital flows and various country-specific institutional and
non-institutional rigidities. The widespread view that the saving-investment coefficient is simply
associated with the degree of capital mobility has been heavily criticized. Alternative
interpretations are commonly found in the literature. The first is the long-run current account
targeting which is likely to produce a high saving-investment coefficient and, most notably, the
inter-temporal budget constraint which implies that saving and investment are co-integrated with
a unit coefficient regardless of the degree of capital mobility. The second approach to interpret
the saving-investment coefficient is related to the country size.

Incomes are generated by production and the economic system is said to be in equilibrium when
all the incomes earned are returned to the income flow through spending. Keynes’ income-
expenditure analysis focuses on the relationship between aggregate expenditures and income.

2.2 empirical literature review conducted the rest of the world

In accordance with Keynes (1936), the effect of interest rate in long run is subjectively lead to
the changes in savings. Meanwhile, an increase in interest rate will make the savings rate become
higher and vice versa. According to Munir, Ullah Awan and Hussain (2010), the real interest rate
is positively affecting the private investment in the long run. This study is conducted from the
period 1973 to 2007 and the ARDL Bounds Testing Approach is applied in time series data.

Glyfason (1993) investigated the relationship between the household saving behavior and
interest rate on savings. The empirical results from 1897 until 1990 of the previous researches
are provided. He classified the variables into two categories which are divided into endogenous
and exogenous variables. The variables include interest rate, savings and the growth. Exogenous
growth model and endogenous growth model was being developed for this study. The result was
found to be consistent with the previous studies that there is positive long run relationship
between interest rate and the saving.

Egbetunde, Ayinde and Balogun (2017) on Interest Rate Liberalization, Financial Development
and Economic Growth in sub-Saharan African Economies, employed panel data cointegration
and error correction model. The research shows that trade openness and price stability exert
greater significance on the economic growth of Sub-Saharan Africa economy than interest rate.
Interest rate was shown to have a negative relationship with the dependent variable which is the
gross Domestic Product.
increase in expected real deposit interest rate. The result obtain is matched with the McKinnon-
Shaw hypothesis and the inappropriateness of the policy of financial repression is being
underscored.

In the empirical study done by Chen (2002), he investigated the causal relationship between
interest rates, savings and income in the Chinese economy.

The data from 1952 to 1999 is being tested by using the co integration test auto regression
(BVAR). The empirical result obtain from the test shows that there is a stable long run
relationship between interest rates, savings and income. In addition, there is unidirectional
causality runs from savings to income, indicates that developed financial institutions can
promote economic growth.

Empirical study conducted in Ethiopia

In accordance with the original Mckinnon Shaw hypotheses real interest rates affect saving also
positively as classical model. Proponents of these hypotheses use tests of models to show their
relation. To test that saving in Ethiopia is positively responsive to real interest rate.

Real interest rate as return to saving is included on the ground of opportunity cost (or tradeoff
between) present and future consumption. According to Mekinnon 1973 and Shaw 1973 real
interest rate in developing countries is expected to have opposite effect on domestic saving. In
calculating the real interest rate, expected inflation is subtracted from nominal deposit interest
rate. However due to the very nature of Ethiopian economy, actual inflation is taken as a proxy
for inflation.The positive interest rate elasticity of aggregate saving however, doubted. it is
argued that higher interest rates over non-financial forms of saving without actually altering the
magnitude of aggregate saving.

The second Mckinnon shaw hypothesis concerned with the positive responsiveness of the
investment to real interest rate through more saving. However, Mckinnon 1973 and shaw 1973
have different views about saving investment transmission for Mckinnon 1973 the saving
investment transmission happens on the basis of his complementary hypotheses. Assuming
indivisibility on investment and transformation of capital market by confining investors to self-
finance in less developed countries, money balance, deposits according to Mckinnon 1973 are
complementary to physical capital. According any investors in LDC should first accumulate the
money balance needed to finance or acquire physical capital. This creates acomplimentarily of
physical capital money balance which is tasted in his study by modified investment function
from Mckinnon 1973, Fry 1980 and Molho 1986

Shaw 1973 on the other hand explains the saving investment transmission from higher real
interest on the basis of his debt intermediation hypotheses. The main emphasis on the role of
deposit accumulation from higher real interest rate in expanding the lending potential of financial
intermediaries. This proposition is going to be tested by the modified model from fry 1980 and
warmand and Thirwall 1994. According to the Warmnd and Thirwall 1994, p 637 the rate of
interest rate is expected to affect investment in two opposite direction. First interest rate as Shaw
1973 May affect investment positively through affecting financial saving i.e. financial deepening
and the supply of credit" and second "interest rate may be expected to affect investment
negatively (holding supply of credit constant) if the rate of interest considered as proxy for price
of credit".developing countries were to suffer from stagnant economic growth, high inflation and
external imbalance. To cope with these difficulties economists had advocated what is known as
financial liberalization Gupta 2004.In elaborating warman and Thirl wall (1994) argument
Gibson and Tasakalot (1884) p. 595 say that "it more credit is only forth coming, if the real
deposit rises and the real loan rises and if the net effect on investment may be ambiguous". The
positive effect from credit availability may be offset by the negative impact of higher interest
rate, Liberalization of financial sector policy emanated from the works of Mckinnon and shaw
1973. Liberalization of financial sector implies abolition of all direct control on interest rate and
credit. In early 1970s large number of developing countries in Africa, Asia and Latin America
under took financial liberalization from which they were following a policy of low interest rate
prior to early 1970s. The main aim of financial liberalization has to develop market oriented and
world integrated financial system mobilization of saving, an efficient allocation of investable
resources and from domestic and foreign sources and acceleration of economic growth.

In Ethiopia, interest rate was fixed during the pre-reform period. During that period privates’
sector was highly repressed. In addition, both bank credit allocation and fixation of interest rate
was determined administratively in favor of public enterprise.Following this the economic
reform in Ethiopia including financial liberalization started in the late 1992.It is started in view
of increasing saving mobilization, enhances investment efficiency, increase growth and the need
to create more conductive in economic environment (Birritu 1992/3.

Empirical evidence on interest rate liberalization in Ethiopia shows that there is no correlation
between real interest rate and savings. Ibrahim 1986. World Bank 1993 also evidenced that there
is a little or no correlation between interest rate and savings.