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Savings and Investment
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Savings and Investment
Savings and Investment• Savings: Funds that are not used
at the moment, balance of the income and spending
• Investment: Resignation from current needs in view of future uncertain gains
Financial System and Economic DevelopmentInput is Man Material, Machine and MoneyMoney, credit and finance are life-blood of
economic systemHuman and physical capital are its
important sources and increase in them require higher and saving and investment
The economic development greatly depends upon capital formation
There is direct relation between capital and output
Theories of Savings and InvestmentThe Classical Prior Voluntary Saving TheoryCredit Creation theoryForced Saving or Inflationary Financing
TheoryFinancial Repression TheoryFinancial Liberalization Theory
Prior Savings Theory (PST)Savings is determinant of investment All Savings in the economy can find investment
outletsAppropriate monetary policy and fiscal policy for
promoting and mobilizing savings for investment and growth
Investment is an alternative to consumptionInvestment which is not financed by prior savings
will generate inflationThis theory does not subscribe to the view that
inflation is needed This theory favors reasonably positive real
interest rates to encourage savings by the public
Cont…How to Achieve it:Some people whose expenditure are
less then their incomesOthers whose current expenditures
exceeds their current incomesIt is achieved by ultimate savers and the
latter called the ultimate investors
Income = Consumption + Savings
Cont…The financial intermediaries achieve
economies of scale in the cost of transferring savings to the investors through pooling of default risk and reducing transaction cost
Financial institutions help development also by creating a efficient payments and transfer mechanism
Credit Creation Theory
In this theory financial system plays a positive and catalytic role by providing finance or credit through creation of credit in anticipation of savings
The investment is financed
through created credit
Credit Credit CreationCreation
Billa
EconomyEconomyTwo SectorsTwo Sectors
PubliPublicc $$
BankBank
PublicPublic
$$
BankBank
AssumptionsAssumptionsFractional reserve banking Fractional reserve banking systemsystem
Demand deposit onlyDemand deposit onlyNo excess reservesNo excess reservesNo cash leakageNo cash leakage
IllustrationIllustration
Required reserve ratio (RRR) =25%(RRR) =25%
Pawan put $200 $200 into the bank as an initial demand deposit
?
First RoundFirst RoundFirst RoundFirst Round
PubliPublicc
$$
BankBank
First RoundFirst Round
$200$200
PubliPublicc
$$
BankBank
First RoundFirst Round
$200$200
$150$150
Second RoundSecond RoundSecond RoundSecond Round
PubliPublicc
$$
BankBank
Second RoundSecond Round$200$200
$150$150
$1$15050
PubliPublicc
$$
BankBank
Second RoundSecond Round$200$200
$150$150$112$112
.5.5
$150$150
Third RoundThird RoundThird RoundThird Round
PubliPublicc
$$
BankBank
Third RoundThird Round$200$200
$150$150$112.5$112.5
$150$150
$112$112.5.5
PubliPublicc
$$
BankBank
Third RoundThird Round$200$200
$150$150$112.5$112.5
$150$150$112.5$112.5
$84.4$84.4
Nth RoundNth RoundNth RoundNth Round
PubliPublicc
$$
BankBank
NthNth Round Round$200$200
$150$150$112.5$112.5
$150$150$112.5$112.5
$84.4$84.4
$84.4$84.4$63$63.3.3
..
..
..
..
PubliPublicc
$$
BankBank
NthNth Round Round$200$200
$150$150$112.5$112.5
$150$150$112.5$112.5
$84.4$84.4
$84.4$84.4$63$63.3.3
..
..
..
..
CreditCredit CreationCreation1st round : 1st round : $200$200
2nd round : 2nd round : $150$150
3rd round : 3rd round : $112.5$112.5
4th round : 4th round : $84.4$84.4
5th round : 5th round : $63.3$63.3
6th round :6th round : ..
7th round :7th round : ..
Credit CreationCredit Creation
TotalTotal??
Calculation of Credit Calculation of Credit CreationCreation
Bank multiplier Bank multiplier ==
11Required reserve ratioRequired reserve ratio
Total deposit incrementTotal deposit increment= initial deposit x banking multiplier= initial deposit x banking multiplier
$$BankBank
$$BankBank
Required reserve ratio (RRR) =25%(RRR) =25%
Pawan put $200 $200 into the bank as an initial demand deposit
?RememberRemember
== 1125%25%
Bank multiplier Bank multiplier ==
11Required reserve ratioRequired reserve ratio
= = 44
Total deposit incrementTotal deposit increment= initial deposit x banking multiplier= initial deposit x banking multiplier
Total deposit incrementTotal deposit increment= $200 x 4= $200 x 4== $800$800
The maximum amountThe maximum amountof deposit createdof deposit created
is is $800$800
$200$200RRR=25%RRR=25%
BankBank
$800$800
Multiplier = 4Multiplier = 4
Theory of Forced SavingsThis theory emphasize on investment with
forced savingsAccording to Keynes and Tobin, investment is
not determined by savings, it is savings which are determined by investment
If the resources are unemployed it would increase aggregate demand, output and savings
If resources are fully employed, it will generate inflation which will lower the real rat of return on financial investments, which will make real balances less attractive to hole and induce holder to investment physical capital
Cont…Inflation changes income distribution in favor of profits earner , which would lead to increase in savings
Inflation imposes tax on real money balances and thereby transfer resources to the Government for financing investment, this known as Inflation Tax Effect
Limitations and dangers This concept of forced saving present inflation as a
desirable phenomenon, which in real life, people fear inflation
The alleged beneficial efforts of inflation can be repeated only if, inflation is unanticipated, while in real life, the public anticipate inflation to significant extent
Inflation can induce undesirable pattern of investment
Inflation means greater economic instability and, therefore, greater uncertainty and risk which can discourage investment activity
Inflation may result in the reduction of exports, lower foreign exchange availability, adverse balance of payments and lower growth
Inflation may increase forced savings but it may discourage voluntary savings
Financial Regulation TheoryFinancial markets are prone to market
failuresThere are certain forms of government
intervention that will make then function better
The lower interest rates through government intervention improves the average quality of loan applications and improves the efficiency
Lending to sectors which are usually shunned by the market
Cont…Conventionally, it is assumed that within any nation
economy, there is a perfect capital mobility and interest rates across regions are equalized by the interregional arbitrage
In practice market imperfections capital does not flow freely in the market across carious regions
This creates a scope for financial market intervention to positively to affect regional development by correcting original misdistribution of capital
The policy can help here by increasing the direct Ventral and state government investments in local economies
Financial Liberalization TheoryFinancial liberalization for promoting
financial and economic developmentAccording to McKinnon and Show, the
developing countries are characterized by the government intervention and interference in the financial system
These countries suffer from poor performance in respect of saving, investment and growth due to financial control, regulation, repression by authorities
Cont…The indicators of financial repression:The existence of indiscriminate distortions in
financial prices such as interest rates and exchange rates
Imposition of interest rates ceiling or fixing nominal interest rates administratively resulting in low or negative real interest rates
Prescribing high reserve ratiosInstituting directed credit programmesInefficient quantitative credit rationing
Cont…Why Financial Liberalization The elimination of financial repression
through financial liberalization, deregulation, privatization is essential to eliminate all the ill effects and distortion, and to put developing economies on high saving, high investment, and high growth path.
Cont…Financial liberalization would result inIncrease in interest rates on variety of
financial asses as they would adjust to their competitive free-market equilibrium level
Increasing in saving, reduction in the holding of real assets
Expansion in the supply of real creditIncrease in investmentIncrease in allocative efficiency of
investment
Shares of public saving in total saving
-20
-10
0
10
20
30
40
50
60
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
China India
Private savings have risen in both countries
0
5
10
15
20
25
30
35
40
45 % of GDP
China India