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