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Consumption, Saving & Investment
Consumption, Saving & Investment
Consumption, Saving
and Investment
© Pierre-Richard Agénor
The World Bank
Consumption and Saving
Investment
Basic facts (Figure 1.1):
Gross domestic saving rates in developing
countries are higher than the rates in industrial
countries (highest in Asia).
Investment rate follows similar pattern (highest in
Asia).
Foreign saving is particularly large in Sub-Saharan
Africa.
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Consumption and Saving
Keynesian Approach
Permanent Income Hypothesis
The Life-Cycle Model
The Basic Framework
Other Determinants
Income Levels and Income Uncertainty
Intergenerational Links
Liquidity Constraints
Government Saving
The Debt Burden and Taxation
Social Security, Pensions and Insurance
Financial Deepening
Empirical Evidence
Keynesian Approach
Consumption is a function of disposable income:
C = (1 - s)(Y - T),
C current consumption, Y - T disposable income;
0 < s < 1 marginal propensity to save.
Merits:
First approximation in empirical macroeconomic
models.
A reflection of the behavior of consumers subject to
liquidity constraints.
The Permanent Income Hypothesis
Consumption is a function of permanent income.
Example : Consumers are identical and live for only
two periods, 1 and 2. Assume perfect foresight.
Budget constraint for period 1:
A1 - A0 = Y1 - T1 + rA0 - C1 (1)
C2 = Y2 - T2 + (1+r)A1 (2)
C2 Y2 - T2
C1 + ––––– = (1+r)A0 + (Y1 - T1) + ––––––––
1+r 1+r
(3)
Simple version of the model:
Household’s objective is to maintain a perfectly
stable (or smooth) consumption path, C1 = C2.
Divide its lifetime resources equally among each
period of life.
Amount consumed by the household in each period
is equal to its permanent income, Yp .
Yp : level of income that gives the household the
same present value of its lifetime resources as that
implied by its intertemporal budget constraint.
Using equation (3) intertemporal budget constraint is
Yp Y2 - T2
Yp + ––––– = (1+r)A0 + (Y1 - T1) + ––––––––
1+r 1+r
Then Yp becomes:
1+r Y2 - T2
Yp = (–––––){(1+r)A0 + (Y1 - T1) + ––––––– }
2+r 1+r
If A0 = 0 and r = 0, YP becomes an exact average of
present and future disposable income.
(Y1 - T1 )+ (Y2 - T2 )
Yp = –––––––––––––––––––––
2
Implications:
Saving (in period 1) is the difference between
disposable income and permanent income.
S1 = Y1 - C1 = Y1 - Yp
Transitory income :
YT = Y1 - Yp
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Income,Cnsumptio,andSvig
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(1
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2
).
Basic Framework:
Two period framework.
Life time budget constraint :
C2
C1 + ––––– = W1 (4)
1+r
W1: life-time wealth.
Suppose that the household’s preferences are
intertemporally additive :
u(C2)
U = u(C1) + –––––– (5)
1+
U: life-time utility;
: rate of time preference which measures the
degree of impatience.
Maximization of (5) with respect to C1 and C2
subject to the life-time budget constraint (4).
By forming the Lagrangien expression:
C2
L = U + [C1 + ––––– - W1]
1+r
: Lagrange multiplier.
The first order optimality conditions are given by:
u’(C2)
u’(C1 ) = , –––––––= –––––.
1+ 1+r
Combining these two equations obtain Euler
equation :
1+r
u’(C1 ) = –––––u’(C2)
1+
When = r, we obtain C1 = C2. The model becomes
the simple version of permanent income hypothesis.
Assume constant elasticity of substitution :
- - -1/
U = {C1 + C2 /(1+)}
where > 1.
The elasticity of substitution between period 1
and period 2 consumption, , is :
= 1/(1+).
Euler equation becomes :
-1/ 1+r -1/
C1 = (–––––)C2
1+
Taking logarithms of both side
1+r
ln(C2/C1) = ln(––––---) (r - )
1+
measures the responsiveness of the change in
consumption between the two periods to changes in
interest rate, r.
The effect of the change in r on consumption and
saving (in period 1) is indeterminate.
Conflict between income and substitution effects.
The greater is , the greater will be the reduction in
C1 (relative to C2) induced by a rise in r.
If is sufficiently large: effect of substitution
dominates; an increase in r reduces consumption
and raises saving.
Age and Dependency Ratio
Predictions of life-cycle model
The young will save relatively little as they
anticipate increases in their future income.
Middle-aged individuals, who are nearing the
peak of their earnings, tend to save the most, in
anticipation of relatively low incomes after
retirement.
The elderly tend to have a low, or even negative,
saving rate, although the desire to leave a bequest
or to cover the contingency of living longer than
expected could provide motivation for saving even
after retirement.
Implication: Aggregate saving rate will tend to fall
in response to dependency ratio, measured as
youth dependency ratio (ratio of under-20 age
population.
Distribution of assets among the population
affects the consumption and saving patterns at the
aggregate level.
The larger the share of total wealth held by the
middle-aged households, the higher the saving rate,
and the higher the growth rate of income in a given
country.
Remark : demographic factors such as the share of
the working population relative to the that of retired
persons are likely to explain only the long-term
trends in saving.
Other Determinants
Income levels and income uncertainty
Recent empirical research has highlighted the fact
that at low or subsistence levels of income, the
saving rate is also low.
Two implications:
in low-income countries the response of saving
motivated bequests;
consumers do not face liquidity constraints;
unemployment insurance ;
saving.
Figure 1.3: positive relationship between gross
domestic saving rates and an indicator of financial
deepening.
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Household and Corporate Saving
Forgoing discussion focused only on saving by
households.
This focus justified in the many developing
countries where private saving rates are essentially
determined by household behavior.
However corporate saving (retained earnings)
may also be significant.
They may respond to different variables than those
affecting the decisions of households.
Importance of this distinction in the aggregate
private saving depends on households’ responses
to higher corporate saving.
If firms retain more earnings, households may have
less by a corresponding amount:
In such conditions, households pierce the
corporate veil.
Aggregate private saving behavior will largely
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Empirical Evidence
Masson, Bayoumi, and Samiei (1995)
Edwards (1996c)
Dayal-Gulati and Thimann (1997)
Loayza, Schmidt-Hebbel and Servén (1999).
Masson, Bayoumi, and Samiei
(1995)
Used cross-country database (developing countries)
to study determinants of private saving.
Results:
increase in public saving associated with higher
national saving, suggesting Ricardian equivalence
does not hold;
decrease in age dependency ratio raises private
saving;
increase in per capita income raises private saving;
changes in real interest rate had no significant
effect on saving;
increases in foreign saving increases both
investment and consumption;
terms-of-trade windfalls have a positive but
transitory effect on saving.
Edwards (1996c)
Used both developing and industrialized countries.
Significant determinants of private saving rate:
rate of growth of per capita income;
deepening);
foreign saving (negative effect);
saving;
social security expenditures: negative effect;
Public Investment
Macroeconomic Stability
Empirical Evidence
Flexible Accelerator
Assumption: production technology is characterized
by a fixed relationship between the desired capital
stock and the level of output.
~
K = ya, > 0,
~
K: desired capital stock; ya: expected output.
Suppose actual capital adjustment is:
~
K = (K - K-1), 0 < < 1.
Gross private investment:
Ip = y.
It relates investment linearly to changes in current
output.
Limitation: profitability, uncertainty, and the cost of
capital play no role.
Cost of Capital
View investment as depending inversely on the
user cost of capital.
Three components of user cost of capital:
opportunity cost; measured by the interest rate the
firm would receive if it sold the capital and invested
the proceeds;
cost resulting from the depreciation of the capital
good;
capital loss (or gain) resulting from the fact that the
price of capital may be falling (rising).
Cost of capital:
cK = PK [i + - (PK / PK)],
~
K = ya / cK
Investment is inversely related to the cost of capital
services.
Limitation: it does not account for the impact of
uncertainty on the decision to invest.
Uncertainty and Irreversibility
Under uncertainty, private investment decisions
may be significantly affected by irreversibility
effect (essentially due to sunk cost).
Because of irreversibility of investment, waiting
has value as it gives firms the opportunity to
process new information before the decision to
invest is taken.
Servén (1997) model:
Examine the effects of uncertainty and
irreversibility on investment.
Assumptions:
Risk-neutral firm must decide whether to invest in
a project in which the initial cost is completely sunk
at the purchase cost PK at the beginning of period
t0 = 0.
It yields a return of R0 at the end of that period.
Future demand for the good generated by the
project is uncertain; as a result, the rate of return
on the project in period t = 1 and beyond, denoted
R, is also uncertain.
Net present value of the anticipated return
stream of cash flows associated with the project:
2
R0
V0 - PK + + 1 (1+)-hE0R,
1+i 1+i h=0
R0+ E0R /i
V0 - PK +
1+i
The conventional net present value criterion
suggests that the investment is profitable and thus
should be made as long as V0 > 0. After
rearranging terms yields:
E0 R - iPK
R0 - iPK + >0, (33)
i
iPK: user cost of capital in the case where the
depreciation rate is zero.
With full reversibility of investment, the future
would not matter; the optimal decision rule would
thus be to invest today as long as:
V1 - V0 < 0,
a condition can be written as (35)
R0 - i PK > Pr(R i PK) E0(i PK - R | R i PK)
i
R0 - i PK: cost of waiting, given by the net return
foregone in period 0 by not investing.
(R i PK): value of waiting, given by the
irreversible mistake that would be revealed
tomorrow if future returns fall short of the user cost
of capital.
The expected present value of such mistake is
measured by the right-hand side of Equation (35):
mistake is made with probability Pr(R i PK);
information, is
E0(i PK - R | R i PK);
= max(V1-V0 , 0).
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Macroeconomic Instability
Irreversibility and asymmetric adjustment costs
cause macroeconomic instability to have large
negative effects on private capital formation.
High level of inflation (characterizes
macroeconomic instability) may lower investment
by distorting price signals and the information
content of relative price changes.
High inflation variability (translated into by
macroeconomic instability) may have an adverse
effect on expected profitability and if firms are risk
averse, their level of investment will fall.
Increase in policy uncertainty: risk-averse firms
reallocate resources away from risky activities
thereby lowering the desired capital level. By the
accelerator effect, this fall may translate into a
reduction in private investment.
Debt Burden Effect
High ratio of foreign debt to output may have
an adverse effect on private investment through
various channels.
Resources used to service the public debt may
crowd out government investments in areas
where large complementarities exist between
public and private capital outlay.
Domestic agents may want to transfer funds
abroad instead of investing them because of the
fear of future tax liabilities to service this debt.
Discourage foreign direct investment by increasing
the likelihood that the government may resort to
the imposition of restrictions on external
payment.
If foreign direct investment is complementary to
domestic private investment, the latter will fall also.
When firms hold a large stock of foreign-currency
liabilities, they become vulnerable to exchange rate
movements.
When a nominal depreciation raises, the burden of
debt and the risk of default increase. This may lead
domestic banks to tighten credit restrictions and
depress investment.
Figure 1.6: negative relationship between debt
burden and private investment.
Fi
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Empirical Evidence
General empirical formation of a private investment
function :
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Lan
k
a
.
1
/
Mo
ne
yg
r
ow
t
hvo
l
at
i
l
it
yi
sd
ef
in
edas
t
he
st
a
nda
r
d
de
vi
at
i
ono
f
re
si
du
al
sf
r
oma
f
i
r
st
-o
r
de
r
a
u
t
or
eg
r
es
s
i
ve
pr
oc
es
sf
ort
h
enar
ro
wmo
ne
yg
ro
w
t
hr
at
e.
Cost of waiting is available when as current return
on investment exceeds the user cost of capital and
equal to this difference.
Value of waiting is defined by the irreversible
mistake that would be revealed tomorrow if future
returns fall short of the user cost of capital.