0.22 Savings, taxation and the private sector  (Page 2/5)

And is this good news or bad news? Remember, we are always concerned with total savings – SP + SF + SG =S, because the S is what is needed to finance all forms of capital formation, which makes economies grow. Actually, the sharp rise in net private savings after 2007 is probably mixed news. It came about as a result of households cutting their consumption and paying down debts, because of their pessimistic outlook on the economy ( and because of a sharp increase in unemployment). And with the meltdown of financial markets in 2007-2010, many households had less capacity to finance a comfortable future retirement. So they tended to save more .

Indeed, one component of savings household savings rose from 1.4% of Disposable Income (DI) in 2005 to 4.6% of DI in 2009, about a 3.5 times increase.

This sudden and unexpected shift in savings behavior was unprecedented. But shifts can occur in emerging nations too, as we will see.

Theories of savings behavior

A theory of savings behavior is also a theory of consumption behavior. Before considering theories of savings behavior we need to consider what is meant by the real interest rate, or more accurately, the real , after tax rate of interest versus nominal interest rate. This distinction will become especially important when we consider financial policy in a subsequent chapter.

The after tax nominal rate (r _t ) is defined as

The elasticity of savings and the real rate of interest

What is meant when economists refer to the interest elasticity of savings? Essentially, they are concerned with the response of savings to the real net-of-tax rate of interest (r*), not the nominal rate of interest.

Savers respond to the real after-tax interest (interest adjusted for inflation), r*, which is defined as in equation (1).

$r*=\frac{(1+r_t)}{(1+p)}-1$

p=rate of domestic inflation as a fraction, not a %.

If the nominal after tax rate of interest=10% and if inflation =5% then the real after tax rate interest is 4.8%. If the nominal rate after tax is 10% and inflation is 20%, then the real after tax rate of interest is minus 9.2%. As a result, savers are heavily penalized, and borrowers heavily subsidized

Negative real rates are not uncommon. In recent years U.S. federal funds rate has been close to zero, while inflation has hovered at about 2.0%. (Note: It is usually permissible merely to subtract inflation from the nominal rate to get the real rate. This is true for lower rates of inflation (say 1% to 5%). But when inflation rates are very high, one must use equation 1 above to find the real rates. Suppose inflation is, say 20%. Then, if r = 10% the real rate is not 20-10, but = 10 – 9.2%.

Many emerging nations have long histories of negative real rates of interest, as we will see.

When returns to savings are interest elastic (Er*>1) and taxable, then savers will respond to changes in the real after tax rate. They will tend to save less when ER*>1, and save more when ER*>1.

Now, we define the interest elasticity of savings Er*, to represent the response of savers to changes in the real interest rate.