SAVINGS

AND THE
FINANCIAL
SYSTEM
INTRODUCTION

Saving plays a key role in determining

growth. It is also important to know how
saving behavior is conditioned in order to
explore the implications for the
macroeconomic policy and the impact of
changing government policies. Much of
the literature on the developing countries
deals with how these models can be used
and tested.
SOME SAVING MODELS

Total saving is the sum of government,

business, and private savings. In developing
countries, most savings is accumulated by
private households and the unincorporated
business sector. Government saving has not
grown much in the developing countries and
corporate saving is relatively small.
KEYNESIAN AND INCOME CONSTRAINED MODELS

 These models start with the simple observation that

consumption may depend upon current income. This model
was overtaken bu more plausible theories in the 1960s and
1970s that allow for consumption and income smoothing
overtime – that is, borrowing to smooth consumption so that
it does not depend completely on the current level of
income. Nevertheless, the simple Keynesian Model
featuring the importance of present income has made a
comeback with the work of Deaton (1989,1991, 1992) and
Hall (1978). Hall argues that expected future income is
subject to random changes so that the current income is the
only reliable predictor of current consumption and saving.
Income smoothing does not occur or is weak
and this vitiates the life cycle model for several
possible reasons:
1. Income smoothing is not possible because of
borrowing constraints and imperfect capital
markets.
2. Income smoothing is not applicable since
many generations live together, weakening
the need for individuals to save.
3. Future incomes are uncertain so it is difficult
to plan over a lifetime.
INCOME SMOOTHING MODELS:
THE PERMANENT INCOME AND
LIFE CYCLE HYPOTHESES
These are models that allow for
consumption over some time horizon
without constraint. Families can
borrow and save at will in order to
smooth their consumption patterns to
compensate for fluctuations in
income.
DETERMINANTS OF SAVINGS
1. Real Interest Rates – Higher real interest
rates stimulate saving by offering higher
financial returns for abstaining from
consumption through the substitution effect. On
the other hand, higher interest rates result in
more income for creditors and this stimulates
consumption through the income effect.
Furthermore, a negative income effect could
manifest as a decline in pension contributions
when interest rates rise.
 DETERMINANTS OF SAVINGS
2. Role of the Government – if the government
raises taxes (increases government saving), incomes
will decline and private saving can also be expected to
diminish, other things being equal.
3. Growth of Income – if workers believe that a
change in income is permanent, in a LCH/PIH world,
consumption would be adjusted upward accordingly
and current saving rate could fall. The increase in
income could also have an impact on the rate of return
on capital and hence the real interest rate.
 DETERMINANTS OF SAVINGS
4. Population Age Structure – the saving rate is
expected to decline as the population ages. A
country with a very low dependency rate can be
expected to have a higher saving rate in an LCH
model.
5. Level of Income – if LCH and PIH are
correct, then saving should not be related to
current income. However several researchers
have found that current income is an important
explanatory variable.
 DETERMINANTS OF SAVINGS
6. Terms of Trade– the terms of trade effect
works through an unanticipated and transitory
increase in income by an improved trade
balance. An unexpected improvement in the
terms of trade can have a positive effect on the
saving rate because it represents a windfall gain
in income and, according to the life cycle and
permanent income models, would be saved.
 DETERMINANTS OF SAVINGS
7. Degree of Financial Liberalization– a
general rule of thumb regarding saving would be
that financial stability and liberalization are
positively related to the rate of private saving,
other things being equal. A predictable and stable
financial environment that offers a range of
financial instruments can be expected to call
forth a higher level of saving from the private
sector than a volatile and capricious financial
and economic environment.
 DETERMINANTS OF SAVING IN
DEVELOPING COUNTRIES AND IN ASIA
Developing countries, such as those in
South Asia and Latin America, generally
saved up to approximately 20-25percent of
GDP between the 1960s and 2000s.
In developing countries, saving rates are
higher for the wealthy.
 DETERMINANTS OF SAVING IN
DEVELOPING COUNTRIES AND IN ASIA
A careful review led by Harrigan
(1998,p.42) conclude that:
“A trinity of fast growth, fiscal rectitude
and slowing population growth have been
associated with high savings in Asia. Where
one or more of these ingredients have been
missing, savings have suffered.”
 DETERMINANTS OF SAVING IN
DEVELOPING COUNTRIES AND IN ASIA
Harrigan (1998) concludes that rapid
income growth, selective terms of trade
effects, financial deepening, reduction in
young age dependency and a reduction in
size of government has boosted private
saving. There was also a significant
depressing effect on saving caused by the
decline in the agricultural share of income.