0.22 Savings, taxation and the private sector  (Page 3/5)

The real interest rate will become very important in our discussions of financial systems.

Whether Er* = 0, or is significantly different from zero is important not only for private sector savings mobilization, but for the effects of financial policy as well.

Theory and empirical evidence

Until about the mid-eighties, most policy-makers and economists believed that Er* ≅0, where again Er* = Elasticity of savings with respect to real after-tax interest rate. This view is quite consistent with the Keynesian tradition. Recall from basic economics the Keynesian savings-consumption function, given as in equation 2.

S=a+sY _d

a=Y intercept

Y _d = disposable income (income after taxes)

s=MPS

In the Keynesian formulation – there in no role for the interest rate in savings decisions. All savings in any year depend only upon disposable income (y _d ) in year t – i.e. savings depend only on current income.

And the Duesenberry relative income hypothesis depicted also allowed for no rule for interest rate See Gillis, Perkins, Snodgrass (5th edition), New York, NY: Norton Publication, Chapter 13. , as the Duesenberry hypothesis was directly in the Keynesian tradition.

However, post Keynesian savings functions, do allow for a role for interest rates. To illustrate consider the MBA hypothesis (Modigliani, Brumberg and Ando, 1963). This is the Life-Cycle hypothesis. See Gillis, Perkins, Roemer and Snodgrass (5th edition), Chapter 13. For the economy as a whole equation 3 presents one form of a life-cycle aggregate savings function:

$\frac{S}{Y}=a+b_{1}H+b_{2}U+b_{3}W+b_{4}D+b_5\mathrm{r*}$

a = y Intercept (autonomous consumption)

H = Rate of productivity growth

U = Life expectancy

W = Societal Net Wealth (assets minus liabilities)

D = Dependency ratio (the ratio of dependents to the working age population), and finally

r* = the real interest rate

So, the life-cycle hypothesis has a role for the real interest rate.

Another, very influential aggressive savings function has been Friedman’s permanent income hypothesis. This is interesting for emerging nations especially. It also includes a term showing a positive relationship between real interest rate and savings decisions.

Friedman’s permanent income hypothesis is depicted in equation (4).

• S = a+b ₁ Y _p +b ₂ Y _t
• • Where a = a constant (y intercept of savings independent of Permanent Income)
  • Y _p = Permanent income b ₁ is a parameter on Y _p
  • Y _t = Transitory income b ₂ is a parameter on Y _t
  • This is a useful hypothesis for many purposes.

The basic point is that people make their savings decisions over a long time horizon that includes their whole life span, just as in the MBA life-cycle hypothesis. Current income plays no role in savings decisions.

We may define in detail the concept. “Permanent Income?” This contribution came from Milton Friedman, Nobel Prize winner who spent his entire career at Chicago. He died at age 94, still writing up to the month he died. In a survey of economists, Friedman ranked as the second most influential economist in the 20th century (after John Keynes).

Permanent income is not merely expected lifetime earnings. Rather, it is the expected lifetime yield from a person’s stock of capital, including both Physical and Human Capital . Keynes, Duesenberry and the MBA hypothesis all ignore Human Capital. Friedman did not. This is not surprising since Human Capital theory was first conceived by at Friedman’s colleagues at the University of Chicago.