Chapter it in to the vocabulary of economics

Chapter 2 : Literature  Review

This
Chapter builds a frame work and the foundation to the research focusing on the
previous studies particular to the research objective in both theoretical and
empirical perspectives. Accordingly, following the traditions this chapter of
literature Review contains two main subsections namely

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

2.1
Theoretical Background and

2.2
Empirical Studies

2.1 Theoretical Background

The
Section of theoretical background specifically focuses on the theories on
Savings and the Growth models which focus on savings and contributory factor of
economic growth.

2.1.1.
Theories and ideas on Savings in the historical perspective

The
picture related to the origin of the concept of savings and inclusion it in to
the vocabulary of economics seem to be blurred in nature. In simple term
savings is the part of the income which is not used for consumption. By looking
at this definition, it can be observed in macro trems savings was there as a
broader concept, may sometimes referred as surplus while digging the history of
economic thought.

Before
Economics was formulated as a separate discipline by Adams Smith (1776), the
views of Mercantilism and Physiocracy which providing the foundation to the
subject of economics tends to discuss glimpse of idea about savings. Though the
concept savings was not properly defined in this context, the blurred picture
given through these ideas provided proxies for further studies to develop the
definition of savings.

“Mercantilism is not consistent with what Keyens said.
Keynes was actually very anti-mercantilist. Keynes’ whole framework for
savings, investment, and current account balances burns a hole in mercantilism
from within its core.”1

Mercantilists’
idea on economic growth and development emphasis on the foreign trade as a
means of capital accumulation and in turn was to increase the power of the
state. The economists such as Willam Petty (1623), North (1641), Jhon
Locke(1632), David Hume(1711) have contributed to these ideas of mercantilism
which was also termed as bullionism and cameralism that focus on nothing more
than three aspects i.e. trade, treasure and power respectively. Though they do
not discuss regarding savings specifically, their main aim of capital
accumulation through trade should have been done by sacrificing the level of
consumption and therefore implicitly the idea of savings was hidden under their
views. (Paul, 1992) Another kind of view
was held by physiocrats with regard to agriculture.They divided society in to
three classes 1) productive class (farmers) 2) The proprietary class (landload)
3) the sterile class. According to them economic growth of the economy depends
upon agricultural advancement ,which in turn depends upon capital accumulation
and its investment in agriculture. Physiocracy has presented growth oriented
theory of consumption and had the idea that hoarding of disposable revenue
should be banned. This implies that physocrates did not valid savings as a
trigger of economic growth much. Even surplus generated through capital
accumulation,it must be re invested in Agriculture. This concept was clearly
explained by Quesnay’s Tableau Economique. (Paul, 1992)

 

Classical
Ideas of savings

The
main stream or classical economist has different definitions and in literature
it has been used to convey three meanings. First, it is usually used to the
economic writings of the period from Adam Smith to J.S. Mill. Second, J.M.
Keynes has used the term to denote Marshall and his immediate followers. Third,
according to Schumpeter, ‘classical’ situation means that the consolidation of
original works that went before.  However,
roughly the period from 1750 to 1850 concerned as the period of Classicals’ writings
and leading members of the school were Adam Smith (1723-1790), Malthus(1766), Ricardo
(1772-1823) and J.S. Mill (1806-1873), J.B.Say. (Paul, 1992)

“”The classical economists” was a
name invented by Marx to cover Ricardo and James Mill and their predecessors,
that is to say for the founders of the theory which culminated in the Ricardian
economics. I have become accustomed, perhaps perpetrating a solecism, to
include in “the classical school” the followers of Ricardo, those, that is to
say, who adopted and perfected the theory of the Ricardian economics, including
(for example) J. S. Mill, Marshall, Edgeworth and Prof. Pigou.”

General Theory of Employment, Interest
and Money,Chap1,page 3

It
seems that classical school is the brain child of the concept of savings or at
least they should be given the prominence for laying foundation to a discussion
on savings as an important economic variable in the economy. Presenting his
work of “Wealth of Nation”(1776), Adams Smith, “Father of economics”,conceived
economic growth in terms of growth of growth of wealth per head. Capital
accumulation is one of the crucial variable in Adam Smiths’ theory of growth.
He identified saving with investment.

“Capitals
are increased by parsimony and diminished by prodigality and misconduct”

Wealth
of Nations ,Book II,Chap.3,page 321

Thus, profit which is
sole motive for investment also becomes the sole motive for savings.The
Smithian growth model will deeply discussed in the section 2.1.2 as a growth
model which explains how Capital Accumulation through savings leads to
economic  growth.

The
Say’s Law which states that “supply creates its own demand” is basis to all
classical reasoning. The entire classical theory based on the assumption that
economy is at full employment level and deviation of it is not a normal
situation. And laissez-faire economy with out government automatically correct
the temporary equilibrium through flexible prices and wages. The complete
Classical analysis explains the determination of prices in tree types of
markets namely Labor market , Money Market and Goods market. Among them
determination of the equilibrium in Goods market tend to be more important in
our analysis since it explains the equilibrium by taking in to account Savings
and Investment as variables. Accordingly, the goods market is in equilibrium
when savings equal investments where both savings and investment are function
of interest rate. Figure 2.1 shows the equilibrium of Goods market explained by
classical model. To classicists, interest is a reward for savings so higher the
rate of interest , the higher the savings and vice versa. Therefore savings
curve is upward sloping as shown in the figure. Lower interest would encourage
investors to borrow and there fore there is a negative relationship between
interest rate and investment and as a result investment curve tends to be
upward sloping. The intersection of these two curve will generate the
equilibrium as shown at point E where total investments in the economy equals
to Savings. This equilibrium will be restored through adjustments of interest
rate if there is a mismatch between savings and investments..

 

 

 

 

 

 

 

 

 

 

 

 

Another
explanation of Classicals relating to Savings and investments is found in the
theory of circular income flow.
The idea of the circular flow was already present in the work of Richard Cantillon. François
Quesnay developed and visualized this concept
in the so-called Tableau économique.
Important developments of Quesnay’s tableau were Karl Marx’ reproduction schemes in the second volume of Capital: Critique of Political Economy,
and John Maynard Keynes’ ‘General Theory of Employment, Interest and
Money’. (Murphy, 1993) The Circular Flow of Income is diagram which shows  a schematic representation of the
organization of the

economy. Decisions are made by
households and firms. Households and firms interact in the markets for goods
and services (where households are buyers and firms are sellers) and in the
markets for the factors of production (where firms are buyers and households
are sellers). The outer set of arrows shows the flow of dollars, and the inner
set of arrows shows the corresponding flow of inputs and outputs. This simple
model of circular income flow has been illustrated in Figure 2.2.

Figure
2.2: Circular flow of Income – Two sector model

 

This
Circular income flow gives importance for savings and Investments as a
leakage and injection respectively. Leakage means withdrawal from the flow. When households and firms
save part of their incomes it constitutes leakage. Injection means
introduction of income into the flow and the basic and major injection is
Investment in the Circular income flow in a two sector in a closed economy.

 

 

 

 

 

 

 

 

 

 

 

                                                                                                                       

 

Source:
www.slideshare.net

 

 

 

Neo
classical’s concerns on Savings seem to be vague and less in literature as most
of their analysis are in micro aspect. Nevertheless they also emphasize the importance
of capital. They much differ from the classical analysis which focuses on long
run problems of economic growth. The neo classical economists on the other hand
concern with problem of allocation of given resources with maximum benefit. This
school is sometimes referred as Marginal school of which Jevons ,Walras, Menger
, Marshall are pioneers.

Nevertheless
, they accepted the income expenditure model which was developed by classical
school in macro aspect.,

 

 

Keynesian
evaluation of savings

Giving
new direction to the economic thought, J.M. Keynes presented his work of
General theory of employment interest and money in 1936. Consideration of
aggregate demand is not just a convenience of exposition , but corresponds to
the emphasis of a school of macroeconomists ,usually referred as “Keynesians.”
Since most of these “demand siders'” operate within a synthesis model they
shall be called “Keynesian Neo classicals”. (Weeks, 1989)  It seems that Keynes has given much
importance to the concept of savings and investment by looking at his main work
“General theory of Employment interest and savings” as he has allotted chapter
six and seven entirely for the concept of Savings and Investment.As Keynes
define Savings ,following classical definition; “Amidst the welter of divergent
usage of terms, it is agreed that saving means the excess of income over expenditure
on Consumption” (Keynes J. M., 1936)

JR Hicks sISLM

·        
Monetarists argument on savings

 

·        
New classical and New Keynesian analysis
of Savings

New Cambridge view

 

 

 

2.1.2.
Analysis of Savings through consumption theories

According
to Keynesians the savings is the part of the disposable income which has not
been used for consumption and therefore considered savings is a function of
disposable income. Accordingly savings function can be written as the opposite
of the Consumption Function,

   Where -C0 is the negative autonomous
consumption/dissavings,

(1-mpc)
is the Marginal Propensity to save (MPS) and the Yd is the disposable income.

.

The
life-cycle hypothesis (Modigliani and Brumberg,
1954; Modigliani and Ando, 1957; Ando and Modigliani, 1963) provides a
theoretical framework of most determinants of saving behavior used in recent
empirical studies. The life-cycle hypothesis suggests that individuals plan their
consumption and savings behavior over their life-cycle. They
intend to even out their consumption in the best possible manner over their
entire lifetimes, doing so by accumulating or saving when they are young and
earning and dis-saving when they are retired. Permanent income hypothesis (Friedman,
1957)suggests that person’s consumption at a point in time is determined not
just by their current income but also by their expected income in
future year again abstracts from retirement saving
decisions of rational consumers. The relative income hypothesis (Dusenberry, 1949) suggests that an individual’s attitude
to  saving is
derived more by his income in relation to the percentage of income consumed by
an individual depends on his percentile position within the income distribution
or compared to the society they live, others than by abstract standard of living. This theory goes
in hand with the concept of conspicuous consumption given by Veblen, where
consumption patterns are based on the imitative and demonstrative psychological
motives of the people which lead to acquire certain standard of living relative
to others in the society they live.

2.1.3.
Growth Models which explicitly highlight Savings

Following
the classic Keynesian footpath, the unforgettable growth model in terms of
importance of Savings was independently developed by Roy F. Harrod and Ensay Domar
in 1939 and 1946 respectively which was later combined as famous “Harrod-Domar
Model”. Despite the fact that similar models was previously developed by other
Keynesian followers; the Harrod Domar model seems to be the most popular among
them. However the importance and the contribution of previous models cannot be
merely ignored and thereby following quote is devoted for them;

“Tugan-Baranovskji’s
model is the head-‘the first and most original’, as Keynes was to say – of a
family of cycle models based on the relationships between savings and
investment which have among their most important exponents Arthur Spiethoff,
Karl Gustav Cassel, and the Keynes of the Treatise
” Pg 240, (Screpanti & Zamagni, 2005) Further, one of the
principal strategies of development necessary for any takeoff stage explains by
American economic historian Walt W. Rostow was the mobilization of domestic and
foreign saving in order to generate sufficient investment to accelerate
economic growth.

 

·        
Harrod –Domar model

 

Harror-Domar
model is a linear stage growth model which shows a functional economic
relationship in which the growth rate of gross domestic product (g)
depends directly on the national net savings rate (s) and inversely on
the national capital-output ratio (c). (Todaro & . Smith, 2009)

The simplest growth model
constructed by Harrord was made up for goods market and production sector. It
has four distinct features given as follows;

1.     
It neglects lag structure of the economy
as this will have no effect on the steady state equilibrium solution.

2.     
A constant desired capital output ratio,
this occurs as Harrod assumes long run real rate of interest

3.     
Savings are a constant proportion of
real income in the economy

4.     
The Labour force is growing at some
exogenously determined constant exponential rate. (Levacic &
Rebmann, 1976)

Harrod-Domar growth model  explains the  functional economic relationship in which the growth rate of gross domestic product (g)
depends directly on the national net savings rate (s) and inversely on
the national capital-output ratio (c). (Todaro &
. Smith, 2009)
This relationship was analyzed by deriving the following equation.

 

 

?Y/Y, represents
the rate of change or rate of growth of GDP. This is a simplified version of
the famous equation in the Harrod-Domar theory of economic growth, states
simply that the rate of growth of GDP (?Y/Y) is determined
jointly by the net national savings ratio, s, and the national
capital-output ratio, c. More specifically, it says that in the absence
of government, the growth rate of national income will be directly or
positively related to the savings ratio.

 

As
another important growth model which discusses regarding Savings, the Solow
neoclassical growth model can be identified. Superseding Harrod Domar model the
Nobel Laureate Robert Solow and Trevor
Swan developed this model in 1956 independently but later clubbed together
and termed as famous Solow-Swan Model. It differed from the Harrod-Domar
formulation by adding a second factor,
labor, and introducing a third independent variable, technology, to the growth equation.

Further
Unlike the fixed-coefficient, constant returns- to-scale assumption of the
Harrod-Domar model, Solow’s neoclassical growth model exhibited diminishing
returns to labor and capital separately and constant returns to both factors
jointly. Technological progress became the residual factor explaining long-term
growth, and its level was assumed by Solow and other neoclassical growth
theorists to be determined exogenously of all other factors in the model. This
neoclassical approach assumes that factor prices are flexible in the long run and
response to excess demand. This allows factor substitution by firms in response
to change in relative factor prices. (Levacic & Rebmann, 1976)

Solow
model can be easily described with the help of following graph.

·        
Kaldor and Pasnetti

It
seems that Kaldor (1956) and Pasnetti (1962-1974) model has contributed for the
construction a model of savings and investment structure of the economy a lot. The
idea of them specially on the account of the fact that distribution of income
between profit and wages determines the savings and investment behavior of the
economy. The origin of the Kaldor- Pastinetti model lies in Kaldor’s
contribution in which he suggested that the level of savings in the economy
could adjust to the level of investment by redistribution of income between
profit and savers. (Fine & Murfin, 1984) Kaldor argues that workers
and capitalists have different savings rates out of wages and profits
respectively. It can be given as follows as a formular;

 

Or                                                       

Where;

S – Savings Rate of the
economy

sw- Savings Rate of the
workers

sp – Savings Rate of
the capitalists

W -Wages

P- Profits

Y- National Income of
the economy

 

Ragnar Nurkse in the 1950s articulated that poverty of the
poor countries may be attributed to the lack of capital formation. The basic
logic of this vicious circle argument is that the greatest obstacle towards the
develop­ment of an economy is poverty. The primary causes of underdevelopment
are so intimately connected that they together form a circle which is vicious.
Ragnar Nurkse explains that the vicious circle implies a circular constellation
of forces tending to act and react upon one another in such a way as to keep a
poor country in a state of poverty. The entire argument is summed up in
Nurkse’s words: “A country is poor, because it is poor.” Or “Because it is
poor, the country does not develop; because it does not develop, it remains
poor.” The vicious circle argument is often explained from the supply side and
the demand side of capital. The supply of capital is governed by the ability
and willingness to save, the demand for capital is governed by the incentives
to invest. Nurkse says: “On both sides of the problem
of capital formation in poor countries a vicious circle exists.” However the
supply side of Vicious circle of Poverty gives more importance to Savings which
can be illustrated as follows in figure 2.4;

Figure 2.4 : Vicious Circle of
Poverty – Supply Side

 

Source:

Share Your Knowledge on Economics

 

 

 

 

 

 

 

 

However , the fact that
whether savings leads to economic growth subject to doubt through some
empirical analysis which has been conducted to test these models in real
context. These empirical studies will be discussed in the Section 2.2.

 

2.2 Empirical Evidence

The issue connected
with savings and economic growth has attracted substantial research interest in
both

1 http://www.economist.com/node/21584095