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Consumption, Saving, and Investment


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Title: Consumption, Saving, and Investment

Consumption, Saving, and Investment
  • Norman Loayza
  • World Bank

Macroeconomic Management for Financial Stability
and Poverty Reduction
  • Introduction
  • Why do we care? Saving, investment and growth
  • Measurement problems
  • Consumption and saving
  • Some facts
  • Basic theories
  • Recent extensions and policy issues

  • Investment
  • Some facts
  • Basic theories
  • Recent extensions Irreversibility and
  • Summary and conclusions

  • Saving and Investment Why do we care?
  • Fact 1 Saving and growth rates are strongly
  • Three alternative views
  • (A) Saving ? investment ? growth
  • (virtuous circles and poverty traps)
  • (B) Growth ? saving
  • (C) Some third factor (firm investment?) drives
  • If (A) is true, growth-oriented policies should
    target saving
  • Even if (A) is false, avoiding large
    saving-investment imbalances contributes to macro
    stability and, thus, to growth (and East Asia?)

  • Fact 2 Investment and growth are strongly
  •   Again three views
  • (A) Investment is the only source of growth
  • capital fundamentalism
  •   The simplest (most popular?) version
  • growth (Investment rate)/ICOR
  • (B) Investment is one among several sources of
  • The others Human capital investment
  • Technical progress (embodied?)
  • Productive efficiency
  • (C) Investment is a consequence of growth
  • If (A) or (B) are true, growth policies should
    target investment among other things.

  • Fact 3 Saving and investment ratios are
    strongly correlated
  • Many explanations
  • (A) There is low international capital
    mobility(Feldstein-Horiokka) Legal/regulatory
    barriers, credit rationing...
  • (B) Governments target (successfully) the current
    account deficit (S-I)
  • (C)There is low domestic capital mobility
  • Financial system imperfections force firms to
    finance Investment with retained earnings
  • D)Third factors (demographics, taxation...) move
    saving and investment in the same direction

  • Severe measurement problems with macro data
  • (1) Statistical
  • Consumption residual from GDP expenditure
  • Saving residual of the residual
  • (2) Conceptual
  • Human capital accumulation, durable purchases
    classified as consumption rather than investment

  • Standard saving measures ignore capital gains ?
    saving very different from change in net worth

Consumption and Saving
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Basic Consumption/Saving Theory
  • The beginnings The Keynesian consumption
    function- only current disposable income matters
  • Ct ? Yt
  • Contemporary mainstream Two major approaches
  • The Permanent-Income Hypothesis
  • The Life-cycle model

  • The Permanent-Income Hypothesis (Friedman)
  • Identical consumers looking into the indefinite
    future. Consumption equals permanent income 
    the annuity value of present and future
    discounted income.
  • Three major implications...
  • (1) Consumption is unaffected by predictable
    changes in income. In simplified version (Hall
  • (2) Transitory income changes are (dis-)saved
    permanent changes are consumed
  • (3) Anticipated income growth reduces saving

  • and some empirical problems
  • (1) PIH fails excess sensitivity of
    consumption to income
  • (2) is clearly violated in the data

  • The Life-Cycle model (LCH) (Modigliani-Brumberg)
    Cohorts of finite-lived consumers with
    hump-shaped income over their lifetime, saving
    for retirement. Consumption depends on lifetime
    disposable income.
  • Three major implications
  • (1) Saving is hump-shaped, too Low when young,
    peak at midlife, negative when old.
  • (2) Income growth across cohorts (but not
    otherwise), as well as population growth, raise
    aggregate saving.
  • (3) Demographics affect aggregate saving Higher
    fractions of old or very young reduce total

Life-cycle Profiles of Earnings and Consumption
Consumption and Earnings
work-related consumption
borrowing and dissaving
  • ... with empirical problems, too
  • (1) LCH fails Consumption tracks income too
    closely there is not enough hump-saving in
    the cross- section data.
  • (2) LCH is not sufficient to account for the
    observed growth- saving correlation.
  • - Besides, old people do not dis-save at least
    not much.
  • - Empirical evidence on the predicted
    relationship between age demographics and saving
    is not conclusive.
  • There is growing evidence that bequests are a
    major saving motive ? the distinction between LCH
    and PIH is weakened.

Consumption/Saving Recent Developments
  • Precautionary Saving
  • Prudent consumers set aside resources to
    shield future consumption against possible future
    unfavorable changes in income, interest rates,
  • Three implications
  • Prudent consumers will lower their current
    consumption when future consumption is more
    uncertain ? higher uncertain raises saving
  • With high future income uncertainty, consumption
    will track current income very closely as in a
    keynesian framework ? can account in part for the
    excess sensitivity
  • Precautionary saving may explain the failure of
    the elderly to dissave they face uncertain
    horizons and uncertain health costs

  • Evidence
  • Limited empirical work Precautionary saving
    models are analytically hard and yield no
    closed-form solutions.
  • Recent evidence suggests that precautionary
    wealth may account for a major fraction of total
    consumer wealth (Carroll and Samwick 1997).

  • Borrowing constraints
  • PIH and simple version of LCH unrealistically
    assume that consumers can freely borrow at going
    rates. In reality, many (most) consumers cannot
    borrow, particularly in LDCs
  • Interest rates do not clear credit markets.
  • Assets such as human capital cannot be used as
  • The simplest approach Constrained consumers
    (denoted c) gear consumption to current income

  • Ct ? Cut (1-?) Yct
  • Empirically, ? is always significantly less than
    1 ? many consumers are constrained.
  • But this approach forbids them from ever saving!

  • More elaborate approach
  • - Combined with precautionary saving, borrowing
    constraints generate buffer-stock saving (Deaton
    1992) Accumulate in good times to buffer
    consumption in bad times when they cannot
  • - Buffer stocks are accumulated and run down
    over short intervals
  • ? they are quantitatively small.
  • Borrowing constraints on housing finance raise
    required levels of pre-purchase saving.
    Empirically, they have a significant positive
    effect on aggregate saving (Jappelli and Pagano

  • Subsistence consumption (not really a new
  • Below a certain income threshold, no saving is
    possible, all income is spent.
  • This view can explain two facts
  • (1) The positive relation between income levels
    and saving rates
  • (2) The positive saving-growth correlation As
    growth rises, more consumers are pushed beyond
    the subsistence threshold and can save

  • Consumption habits
  • Standard models of consumption/saving assume
    inter-temporal separability of preferences. With
    habits, todays happiness depends on
  • (1) Todays consumption and,
  • (2) A stock of past consumption (internal
    habits) or others consumption (external
  • Habits act as a drag on consumption levels.
    They are consistent with three facts
  • Excess sensitivity. Consumption changes are
    predictable (by past consumption changes)
  • Positive impact of growth on saving consumption
    lags behind income growth due to the habit drag
  • Low consumption early in the life cycle, due to
    the anticipated cost of having to feed the habit

Policy Issues Related to Saving
  • Is there a distortion causing socially too low
  • Self-perpetuating traps of under-saving and
  • Saving offers insurance in imperfect world
    financial markets (sunspots, herd behavior)
  • Moral hazard in retirement saving
  • Too low public saving (if there is no Ricardian
  • ... but countries can also save too much
  • Forced saving (the Soviet bloc)
  • Excessive mandatory saving
  • Too much risk/too few diversification

  • If national saving is too low, how to raise it?
  • Public saving
  • Tax incentives
  • Institutional/regulatory reform
  • Financial system
  • Pension system

  • Does higher public saving raise national saving?
  • Ricardian equivalence implication of PIH What
    matters for private consumption is the present
    value of current and future public recurrent
    expenditures ( NPV of taxes).
  • ? A change in the time profile of taxes without
    changing their present value does not change
    private consumption.
  • ? Tax and deficit financing are fully
  • ? An increase in public saving will be fully
    offset by a matching decline in private saving

  • This is strictly true only under stringent
  • (i) Consumers look far into the future
  • (ii) They face no borrowing constraints
  • (iii) Taxes are not distortionary
  • (iv) Public and public consumption are
  • ? It cannot be literally true. But is it a good
  • The bulk of evidence is against full Ricardian
  • Offset coefficients are around .23-.65
  • They are somewhat lower for expenditure cuts
    than for tax increases.
  • Provisional conclusion Public saving is an
    effective tool to raise national saving.

Private/Public Saving Offset Coefficients
  • Do tax incentives raise national saving?
  • - General tax incentives
  • Raise the after-tax rate of return
  • ? ambiguous impact on private saving
  • - Targeted incentives on specific assets (IRAs,
    401k, etc.)
  • Encourage portfolio reshuffling to collect the
    tax break
  • Unclear if they have any effect on total
    private saving
  • ? Evidence for US, OECD is inconclusive.
  • Two points to note
  • Even if there is a positive impact on private
    saving, there is also a fiscal cost
  • ? still unclear impact on national saving 
  • Distributive aspect Asset reshuffling
    easier for wealthier consumers
  • ? possibly regressive redistribution

Digression Saving and Interest Rates   
  • Three effects of real interest rate changes
  • (1) Substitution effect Tomorrows
    consumption becomes relatively cheaper ? positive
    impact on saving, bigger the higher
    inter-temporal consumption substitutability
  • (2) Income effect Less needs to be saved to
    enjoy a given level of consumption tomorrow ?
    negative impact on saving
  • (3) Human wealth effect The present value of
    tomorrows labor income declines ? positive
    impact on saving
  • In the LCH, further complications, as interest
    rate changes trigger off distributive effects
    across cohorts.

  • Then, what is the net effect of interest rates
    on saving?
  • Total net effect is theoretically ambiguous, and
    likely small.
  • Empirically, little if any effects on saving.
  • A recent approach Consumption-level-dependent
    substitution elasticity (Ogaki, Ostry, and
    Reinhart 1996)
  • At low consumption levels, little substitution
  • At high consumption levels, stronger
  • ? Interest rate effect stronger for richer
  • Some empirical support for this view.

  • Do institutional reforms raise national saving?
  • (1) Financial Reform
  • Typically, three aspects
  • Higher real interest rates
  • Easing of borrowing constraints assets become
    more easily collateralizable and, hence, more
  • Enhanced portfolio choices

  • ? Clear impact on portfolio allocation
  • - Financial savings rise
  • - Flight capital returns (? measured saving
    may rise)
  • ? Likely positive impact on the efficiency of
  • ? But likely adverse direct impact on volume of
  • Easier access to consumer credit (Mexico 1990s)
  • Better access to risk diversification ? reduced
    precautionary saving
  • ? Empirically,
  • - Negative effects cross-country regressions
    (Loayza, Schmidt-Hebbel, and Serven 2000)
  • - No systematic effect 8 country-case studies.
    Negative in Korea and Mexico, Positive in Ghana
    and Turkey, and Negligible in the rest (Bandiera
    et. al 2000)
  • - No effect when expenditures on durable goods
    are considered as saving (negative otherwise)
    India (Loayza and Shankar 2000)

  • (2) Pension reform Transition to fully-funded
    pension system
  • Effects studied mostly with simulation models
    but also with cross-country regressions and case
  • The direct effect
  • Transition financed by issuing public debt No
    direct effect (its only a conversion from
    implicit to explicit public liability)
  • Transition financed by reducing the non-pension
    public deficit (lowering net benefits to current
    retirees, imposing higher taxes on current
    generations, or lowering government
    expenditures) Saving levels of current
    generations decline while those of future
    generations rise, although their saving rates
    will not necessarily change.
  • Higher mandated saving (with possible over-saving
    by borrowing-constrained consumers) Singapores
    Central Provident Fund - minimum 25.

  • The side effects (mostly in the long run)
  • Higher growth (from reduced distortions)
  • Capital market development
  • Higher rates of return on pension assets
  • What does the evidence say?
  • - Chile Private saving/GNP rose from 1 (1980)
    to 17 (1992). But was it due to pension
  • - General Countries that increase the funding of
    their mandatory retirement programs tend to
    achieve higher private saving rates
  • Chile 3.8 p.p. of the increase in saving rate
    attributed to pension reform (Schmidt-Hebbel
  • Cross-country pay-as-you go systems had negative
    effects on saving
  • Overall, the effect on saving is mainly in the
    long run and through mandated saving

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Basic Investment Theory
  • Two conventional views
  • (1) The neoclassical model (Jorgenson)
  • F(K) ucK
  • where the user cost of capital depends on
    interest rates and the relative price of capital
    ucK (rd)pI ignoring taxes
  • (2) Tobins q model Investment depends on the
    ratio of the value of the firm to the replacement
    cost of its productive capital (q)

  • In both approaches, (convex) adjustment costs
    need to be assumed to transform a static problem
    into a dynamic one
  • Under appropriate assumptions, the two approaches
    are essentially equivalent (Hayashi 1982)
  • Empirically, these models are not successful.
  • Main reason The estimated effects of the user
    cost of capital are usually very small and often
  • Empirical models explain only a small part of
    the observed variation in investment.

Recent Developments
  • Financial Factors and Investment
  • Modigliani-Miller (1958) Internal and external
    funds are perfect substitutes ? firms investment
    decisions are independent from their financing
  • In reality, informational asymmetries, cost
    monitoring, and contract enforcement problems
    lead to imperfect substitutability.
  • Two main results from this literature (e.g.
    Fazzari et al 1988)
  • (i) Unless all loans are fully collateralized,
    external finance is more costly than internal
  • (ii) The premium on external finance is
    decreasing in net worth.

  • Implications
  • The financial accelerator Adverse shocks to net
    worth raise the premium and reduce investment (?
    shocks are amplified)
  • Interest rate changes affect investment not only
    through (i) the cost of capital, but also through
    (ii) net worth (impacting on the cost spread),
    and through (iii) the availability of internal
  • Taxes have marginal effects (on marginal
    profitability and cost of capital) and also
    average (income) effects on investment, through
    internal funds availability.
  • Financial reform can reduce the cost spread and,
    thus, raise investment.
  • Empirically, there is strong evidence that the
    availability of internal funds affects investment
    positively. The impact seems to be larger for
    small firms.

  • Irreversibility and Uncertainty The Options
  • Three basic facts (Dixit-Pindyck 1994)
  • (i) Investment is irreversible
  • ? adjustment costs are asymmetric Projects
    cannot be undone - without high cost
  • (ii) Future returns are uncertain
  • ? waiting allows new information about future
  • (iii) Investors can choose the timing of
  • ? investment can be postponed
  • (i)(ii)(iii)? Option value of waiting
    Investing kills the option to wait

  • New Investment rule Invest if naive NPV
    value of option to wait (and not just NPV 0)
  • Properties of the option value
  • It only depends on bad news (good news is
  • It can be very large even with small uncertainty
  • ? Uncertainty can be a powerful investment

  • The bad news principle
  • Projects costs pk
  • Yields R0 today and an uncertain R every future
    period let ER R0
  • Discount rate is r

  • Reversible investment
  • ? invest now iff current profit ? user cost
  • R0 ? r pk
  • Irreversible investment, and waiting yields
  • ? invest now iff current profit ? user cost
    user cost EPV of bad news.
  • If uncertainty is fully resolved next period
    invest now iff
  • R0 ? rpk Pr R R
  • current profit ? user cost of capital Prob.
    irrev. mistake EPV mistake

The bad news principle with multiple projects
a productivity improvement leading to inaction
Return per period
Return per period
user cost of capital
user cost of capital
Real wage
Real wage
Irreversibility and Uncertainty Implications
  • At the firm level
  • (1) Higher uncertainty raises the profitability
    threshold for positive investment (enlarges the
    range of inaction)
  • But
  • (2) Higher uncertainty may also raise expected
  • (1) (2) ? the short term impact on investment
    is ambiguous
  • And
  • (3) Even if (1) outweighs (2), long-run impact
    is ambiguous due to hangover effect Higher
    uncertainty implies more excess K
  • At the aggregate level
  • (4) Investment displays considerable inertia -
    the response to aggregate shocks/policy changes
    is gradual
  • (5) The response depends on initial conditions -
    i.e., where individual firms are relative to
    their investment thresholds.

Irreversible Investment Applications
  • Interest rat uncertainty (Ingersoll-Ross)
  • Tax uncertainty (Hasset-Metcalf)
  • Real exchange rate uncertainty (Dixit-Krugman)
  • Debt overhang (uncertain debt service/anticipated
  • Main message Stability of incentives is as
    important as their level.
  • Reform credibility
  • Why the sluggish investment response to policy
  • Possibility of reform reversal ? value of
  • Imperfect credibility of reform leads to
    investment pause
  • Problem Endogenous reform collapse may occur
    due to lack of investment (? coordination

Irreversibility Empirical Evidence
  • Few structural models too difficult to do
  • Many reduced-form studies of uncertainty-investmen
    t link (Almost always significantly negative)
  • Economic instability (volatility of RER, TOT,
  • Political/social instability (political
    violence, civil unrest...)
  • But is irreversibility the reason? Other
    possible explanations
  • Risk aversion/incomplete markets
  • uncertainty has a negative impact on investment
    (Zeira 1989)
  • Disappointment aversion
  • Bad outcomes are most important
    (Aizenman-Marion 1995)
  • negative effect on investment

Private Investment and Economic Instability
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  • Socio-Political/Institutional Factors
  • Property Rights
  • Poorly defined or poorly enforced property
  • (1) Raise transaction costs
  • (2) Make investment returns more uncertain
  • Corruption
  • Informal taxes on investment
  • Like formal taxes, they raise project cost
  • But are hard to predict ? raise uncertainty as
  • Empirically Reduced-form models including
    indicators of
  • Property rights/contract enforcement
    (Knack-Keefer 1995)
  • Corruption (Mauro 1996)
  • Overall institutional quality (civil liberties
  • ? Almost always find significant effects

Private Investment and Socio-Political Variables
  • Coordination Failures
  • Strategic interactions among investors can lead
    to sub-optimal (typically under-) investment.
  • Two examples
  • 1. Increasing returns (Kiyotaki 1990)
    Profitability of individual firms depends on
    overall activity  ? on overall investment.
    Individual firms ignore their contribution to
    overall investment. ? Multiple equilibria with
    self-fulfilling expectations
  • If each firm anticipates low aggregate
    investment, it does not invest.
  • If it anticipates high aggregate investment, it
    will invest.
  • ? The economy may get stuck in a pessimistic

  • 2. Irreversible investment with private
    information (Gale 1994)
  • Investment by others is informative (about
    profitability, technology)
  • It pays to wait for them to invest
  • ? Equilibrium with too much waiting and
  • Implication With coordination failures, the
    social value of investment differs from
    (exceeds?) its private value
  • ? Role for investment-oriented policies

  • Public saving is an effective tool to raise
    national saving
  • Financial reform will improve the efficiency of
    intermediation and foster investment and growth.
    It will likely reduce saving in the short to
    medium run
  • Pension reform likewise has beneficial effects on
    efficiency and growth. Its direct impact on
    saving appears to be positive.
  • The level of income is one the most important
    determinants of the saving rate. Any reform that
    increases income will have a long-run positive
    effect on saving.

  • Investment is highly sensitive to economic
    instability. The stability of the incentive
    framework is at least as important as the level
    of the incentives themselves
  • Coordination failures may lead to
    under-investment and justify policy intervention
    to raise investment
  • Elimination of macro-instability (large deficits,
    high and volatile inflation...) is a key
    requirement for private investment to take off
  • Socio-political instability, corruption and weak
    institutions are major investment deterrents.
    Institutional reform may play a major role in
    fostering investment