Factors Affecting the Savings Ratio - Essay Example

Impact of Interest Rates on the Savings Ratio Introduction The savings ratio signifies the percentage of the income that is saved without spending. With a fall in the saving ratio it may be inferred that there is an increase in the consumer spending which is usually financed by additional borrowing. In any economy the marginal propensity to spend and save will differ from individual to individual. In general people with lower income tend to have a higher propensity to spend and any changes in the government policies with respect to direct taxation and level of welfare benefits will have a serious impact on the propensity to spend. Normally the following are the key factors that determine the level of consumer spending and the resultant saving potential in any economy (Tutor2U): The level of the real disposable income in the hands of the households The interest rates and the availability of credit The increases in confidence of the consumers The changes in the financial wealth of the households and The changes in the levels of employment and unemployment in the economy Among the above factors this paper presents a report on the impact of the changes in the interest rates on the consumer spending and the resultant savings ratio: Factors affecting Consumption Function A change in any factor that has an impact on the consumption apart from the income is said to result in a shift in the consumption function and this would ultimately affect the saving potential of an individual. The factors affecting the consumption function are: Change in the Interest Rates A cut in the interest rate will enhance the consumption at all levels of income and will lead to an upward shift in the consumption function. Lower interest rate act to reduce the cost of servicing any mortgage or other debt and thereby increases the effective disposable income in the hands of the homeowners. Contrastingly a period of higher interest rate is expected to curtail the consumer spending. Change in the Household Wealth A rise in the prices of assets like a home or shares will encourage higher level of borrowing and an upward swing in the consumption function Change in the Consumer Confidence Any apprehension about rising unemployment levels resulting in worsening situations of income level might result in a reduced confidence level of the consumers and a fall in the spending at all levels of income. In contrast to this situation any expectations of improvement in the health of the economy would increase the confidence of the consumers and the resultant planned spending. The changes in the spending behaviour of the consumers affected by the above factors will have a direct bearing on the saving potential of the individuals. The consumption function thus determines the amount of saving that an individual can earmark out of his disposable income towards saving. This ultimately goes to decide the saving ratio which is a factor of the saving against the disposable income. Saving Saving represents a decision to postpone the consumption by saving the money out of the disposable income. There exist a number of motivations behind the saving habits of individuals: Precautionary Saving With a view to avoid the future inconveniences and other potential financial issues that may arise due to unemployment or any other reason, people resort to saving by smoothing their present spending. Building Spending Power Saving presently will enable any one to acquire a future spending power and to meet any major financial commitments at a future data that may arise due to unexpected happenings. Interest Rates and Savings The incentives offered by higher interest rates from banks, building societies and other financial institutions may generate more willingness to save. Desire to Bequeath Strong desire to bequeath more wealth to future generations act as a strong motivator for saving habits Impact of Life Cycle of Consumers At the young age the consumers may borrow more to meet their commitments and once they become older with the easing of the commitments the disposable income and the saving potential increases. Interest Rate and Saving Ratio Although it is reasonably certain that the rate of interest influences the way in which any given level of aggregate disposable income is allocated between consumption and saving it is not equally certain that a higher interest rate means less disposable income will be allocated to consumption and more to saving and vice versa. A change in the interest rate may thus cause an increase or decrease in the total amount saved. By a careful examination of the saving behavior of an individual by the factors enumerated above, it may be possible to ascertain why the saving ratio may go in either direction. Apart from the desire to leave an estate, the individual's current saving in all other cases may be viewed as deferred consumption. Because the typical individual prefers a dollar of present consumption to a dollar of future consumption (denoted by a positive time preference) he is willing to abstain from a dollar of current consumption only in exchange for something more than a dollar of future consumption. Assuming a stable price level, the rate of interest a person can receive on saving indicates the amount of future consumption, he can secure in exchange. For example at a rate of 5 percent interest he can exchange one dollar of current consumption for approximately one and a half dollar in eight years time. Thus the individual who aims at maximizing the total utility over the time will substitute future consumption for present consumption up to the point at which the marginal utility derived from the expenditure of the interest-augmented future dollar is just equal to or just greater than that derived from the expenditure of the current dollar. Relationship between Interest Rates and Saving Ratios - Substitution Effect and Income Effect Given the typical individual's schedule of preferences it appears that the amount of saving is directly dependent on the rate of interest. However, while a higher rate of interest tends to produce a substitution toward more future and less present consumption. It also increases the individual's future income beyond what it would have been otherwise. Therefore a higher interest rate raises his future income relative to his current income which in turn may lead him to take a part of this larger future income in the form of present consumption. Whether an individual with a given current income will save more on balance at a higher interest rate then depends on the relative strength of the 'substitution effect' which works toward more saving at higher rates of interest and the 'income effect' which works towards less saving at higher interest rates. For those lower income individuals who will save only a relatively smaller part of their incomes even at higher interest rates, the substitution effect will outweigh the income effect; their saving will vary directly with the changes in the rate of interest. On the contrary for those individuals with larger income levels, who tend to save relatively larger portion of their incomes, the income effect may outweigh the substitution effect; higher interest rates may decrease the amount of current saving. For low income savers a supply curve relating to the amount of saving to the rate of interest will slope upward to the right over any realistic range of interest rates. For high income savers this supply curve may at some rate of interest bend backwards indicating that saving decreases for all rates above that at which the backward bend appears (R.LCrouch). A special case in which an individual's supply curve will be backward sloping at all rates of interest occurs when the individual saves whatever amount is needed to realize the goal of accumulating a fixed sum by a particular future date. The higher the interest rate the smaller is the amount he has to save over the time period in order to realize the monetary goal. Impact of Interest Rate on Dissavers The argument that a higher interest rate may cause some individuals to save more and others to save less is substantiated by the fact when it is limited to those individuals who actually save some positive amount as opposed to dissavers who save a negative amount. Dissavers finance current consumption in excess of current income either by drawing down past saving or by borrowing. The interest rate however may also affect dissavers. For these individuals a higher interest rate will in practically all cases discourage dissaving and encourage saving. This is so because all the other things being equal, no one wants to borrow at a higher interest rate than a lower interest rate - which mean higher rates on installment credit purchases of cars and the like and on personal loans - will if anything discourage borrowing (M.J. Hamburger (1967); W. Weber (1970). To the extent that higher interest rates make dissaving smaller than it otherwise would be, the amount of saving to this extent varies directly with the interest rate (Edward Shapiro) Economic Impact of Interest Rate Changes In the traditional economic theory, there is a crucial role being played by saving rate, as there is a direct correlation between the saving rate and investment rate. Thus the economic growth is influenced by the changes in the saving rate which in turn is affected to some extent by the changes in the interest rates among other factors. Although most of the economists opine that according to the conventional wisdom the holding of the interest rates lower by the central bank of any country will protect the country from tripping back to recession and deflation. However there are contradictory views that the higher interest rates would actually encourage households to spend more and not less. The problem with lower interest rates is that it may create economic distortions like excessively weaker currency, or inefficient investment. Low interest rates themselves may discourage the consumers to curtail their spending with a view to save more. The lower interest rates become advantageous to the debtors but not to the savers. In any economy the importance of saving for capital formation can not be underestimated. As observed earlier there are several determinants of saving rate. The household saving is negatively determined by government saving, aging populations and real interest rates, with positive effects coming from changes in terms of trade and from productivity growth (Werner Dirschmid and Ernst Glatzer) If the savings rate in any country does not increase at a faster rate the economic growth of that economy will deteriorate. This calls for appropriate monetary and fiscal policies to boost the domestic saving. In forming the fiscal monetary policies normally the interest rate policy and the tax exemption policies are relevant to be considered. In certain economies the gap between the domestic savings and investments is filled by the net capital inflows from abroad. But excessive dependence on the capital inflows from foreign countries would pose its own problems. If with a view to increase the saving any government adopts fiscal and monetary policies which have a bearing on the real interest rates, both the fiscal and monetary policies may become deterrents to saving particularly in the domestic sector due to reasons discussed. Conclusion In view of the available evidence many economists have taken an essentially skeptical position. They recognise that a change in the interest rate may change the aggregate amount of saving out of any given level of disposable income. But they also insist that although the change in saving is most likely to be in the same direction as the change in the interest rate, it may possibly change in the opposite direction. This amounts to saying that interest rate changes of the size found in actual experience do not on balance greatly influence the amount of personal saving at any level of disposable income. Forces working on both directions are partially offsetting and produce a net effect that is believed to be small. References Edward Shapiro (1998) 'Macroeconomic Analysis' Edition V Galgotia Publications Pvt. Ltd. India M.J. Hamburger (1967) 'Interest Rates and the Demand for Consumer Durable Goods' American Economic Review December 1967 p 1131 - 1153 R.L. Crouch (1972)'Macroeconomics' Harcourt Bracce Jovanovich Tutor2U 'Macroeconomics/International Economy - Consumer spending and Saving' W. Weber (1970) 'The effect of Interest Rates on Aggregate Consumption' American Economic Review April 1978 p 591 - 600 Werner Dirschmid and Ernst Glatzer 'Determinants of the Household Saving Rate in Austria' Read More