Problems Associated With Low Savings Rates - Assignment Example

Question a) By sing statistics on real and nominal GDP, it is possible to calculate an implicit index of theprice levels for the year. This price level index is called the GDP deflator and it is given by the formula GDP Deflator = (Nominal GDP/Real GDP)*100 GDP deflator can be seen as a conversion factor which transforms real GDP into nominal GDP. In this case, real GDP will be given by; Real GDP (2003-2004) = (Nominal GDP/GDP Deflator)*100 = (590/95)*100 = A $. 621.052 Growth = 621.052 - 590 =A $. 31.052 % Growth = (31.052/590)*100 =5.26% b) Real GDP (2003-2004) = A$. 621.052(as shown in part a) Real GDP (2004-2005) = (650/102)*100 =A$. 637.25 Therefore, change in Real GDP between 2003-04 and 2004-05 will be given by; Change = 637.25 – 621.052 = 16.198 % change = (16.198/621.052)*100 = 2.6% (virtual.yosemite.cc.ca.us, 2011). Question 2 Consumer Price Index is largely used as a cost of living index, but in technical terms it is not. CPI measures average change over time in prices paid by consumers for a fixed basket of goods and/or services. Cost of living index would however measure all changes over time in the amount consumers need to spend to reach a certain level of utility or standard of living. CPI ignores vital changes in taxes, water and air quality, crime levels, consumer safety, and quality of education. Additionally, personal experiences may vary from what is indicated by the CPI, this is because an individuals purchasing pattern may differ from the standard market basket. Families which have children have different buying patterns than households of the elderly. The CPI also does not represent the experiences of rural dwellers. CPI measurement limitations fall into two broad categories. Sampling errors CPI only measures the prices of just a sample of items from a sample of shops in a sample of localities. Those items are chosen randomly by the using of Consumer Expenditure Survey (CES). Non-sampling errors These are usually more significant than sampling errors. They bias the CPI upwards or downwards, so the CPI would normally tend to report higher inflation than what consumers are actually experiencing. a) Invention of LCD TVs will lead to lower level Substitution bias Consumers usually tend to respond to changes in price by substituting relatively cheaper goods for goods which have become more expensive. This is referred to as substitution bias. Substitution bias can either occur within item categories (lower level bias) or across item categories (higher level bias). b) Introduction of GPS units in cars will lead to Quality Change Bias If a product is 5% better than its predecessor, and its price rises by 10%, then the Bureau of Labor Statistics will record a price increase of only 5%.This reflects what is known as Quality Change Bias. c) Increased personal computer purchase in response to decline in their price will lead to New Outlet/Discount Bias. A discount outlet or price fall gives consumers the opportunity to purchase the same goods at a lower price. The current CPI ignores these price changes. Totally taking the price changes into account usually biases the CPI downwards. d) Greater use of bicycles after price levels increase will lead to high level substitution bias. Since consumers are switching from using cars to using bicycles, this is referred to as higher level substitution bias. e) Higher fuel taxes will lead to high level substitution bias. Since consumers will switch from fuel to using other energy sources, this will be a case of higher level substitution bias. Question 3 Factors that affect the rate of savings in an economy: A case study of Bangladesh Saving is defined as the process of setting aside a certain amount of current income for use in the future, or any resources that may be accumulated in this way over a certain period of time. How much individuals in an economy save is affected by their personal preferences for future over their present consumption and also their expectations of their future income. If people consumed more than the value of their earnings, then their saving would be negative and they would be said to be de-saving. Individual saving is measured by estimating the disposable income and then subtracting the current consumption expenditure. An increase in net worth shown on a balance sheet reflects the measure of business saving. Total national saving is shown as the excess of gross national income over the Nation’s consumption and taxes. Saving is very important to economic growth because of its relation to levels of investment i.e. an increase in productive wealth requires that some people refrain from consuming all their income and therefore make their savings available for future investment. National savings can be termed as being the sum of personal savings, business savings, and state savings. Businesses do save when all their profits are not distributed. These sums are however usually quite small when seen on a macroeconomic scale. Many states often run public budget deficits, such that they rather dis-save. All this would facts lead to the conclusion that personal savings are by far the largest and most important constituent of national savings. Savings can also be defined as the proportion of disposable income that is not spent (Anderton, p197). Disposable income on the other hand is income after deducting direct taxes and adding all other benefits. Those factors can be categorized into two broad categories; short run factors and long run factors. According to Anderton (p 198), short run factors are wealth and rates of interest. Long run factors are expected rates of inflation in the economy, the structure of the population in a given economy, the level of employment in an economy, availability of credit and consumption levels. There are many motivations/incentives for saving: Precautionary saving:- People save more because of a fear of being unemployed in future. Savings allows people to smoothen out their spending even when incomes fluctuate. Building up potential future spending power:- Saving more today is a choice made to defer spending now to finance major spending commitments that may arise in the future like saving for the deposit on a new car, mortgage or a wedding. People are also getting increasingly aware of the need to save more in order to build up assets. Rates of Interest and saving:- There is usually a greater willingness to make savings because of the motivation of high rates of interest from building societies ,banks and other financial institutions. Inheritance-: a lot of people have a great desire to pass on bequests of an amount of wealth to their future generations. Saving and the nature of consumer’s life-cycle:- a majority of Young people are net borrowers of money because they have to fund their studies, purchase property and buy many expensive consumer durables. As they grow older, their net incomes from work always tend to rise as their spending commitments reduce leading to an increase in net saving ahead of retirement.  Determinants of savings rates A tri-lateral relationship that exists among savings, level of consumption, and amount of income is the key determining factor of the amount of personal savings. Given a certain level of income, the decision to purchase goods and services which is consumption negatively affects amount of savings. Savings adjust passively to levels of consumption and also income. Savings represent what is called a resource slack, i.e. buffering shocks in amounts of income and the level of consumption. (Schmidt-Hebbel and Serven, 1999) On another side, savings can be planned in various binding agreements, e.g. pension schemes, with consumption levels passively adjusting to the changes in income. In other words, savings may arise from some compulsory tendency of postponing and renouncing banal consumption i.e. greediness or, they can be as a result of rapidly rising income levels, with higher amount of consumption taking place altogether. In addition, savings can be also as a result of negative expectations about the amounts of future income e.g.as in a case when one is afraid of being sacked in the near future. Thus they know family hardships will come and therefore they reduce their absolute level of consumption. (Bernheim and Shoven, 1991) Income levels depend on GDP levels but, in this era where the financial markets are becoming more and more important and there also exists a large wealth in terms of assets, it also depends on asset prices movements and the yield of financial instruments. The major factors that determine consumer savings in the economy can be summarized as follows: The level of real disposable income in a household, prevailing Interest rates and the availability of accessible credit, Consumer confidence about the future, Changes in household financial status or wealth and Changes in levels of employment and unemployment. (McRae, 2004) Wealth According to Anderton (p198), the wealth that a household owns falls into two categories: physical wealth which consists of things like houses, cars and furniture, and monetary wealth which consist of cash at hand, money in bank, pension rights among other rights. The amount of wealth affects savings rate in that the more wealth is available, the higher the level of savings. This is because people will have more money at their disposal which can be saved.(Karl, Fair 2004).since Bangladesh is a generally poor country, households have few wealth and therefore the level of savings is very low. In static terms, rich people save and most poor people dont. At the same time, people’s individual behavioral rules also play an important role in determining amounts of savings. Rates of interest Suppose a household borrows money the finance the buying of a durable good e.g. a car. If the interest rate of the money borrowed goes up, it means that the monthly repayment on the loan increases, thus the price of goods bought by borrowing increases. This will automatically lead to a fall in consumption levels in the household which in turn translates into higher levels of savings. Additionally, if savings earn interest to the saver, a rise in the interest rate that the savings attract will encourage more saving and thus the level of saving in the economy will generally go up. (Mankiw, 2008.p447) Expected Rates of Inflation Inflation can be defined as a rise in general level of prices. If households in an economy suspect that prices are bound to rise in the near future, they tend to increase their consumption now. Thus in the short run, savings will tend to decline. However, inflation erodes the real value of money thus people will tend to save more in the long run. This is because they understand that the actual value of money has declined and therefore they need to save more to be able to finance their future consumption. Cost push inflation in Bangladesh is high and therefore people spend almost all their incomes thus the level of savings is very low. (Boyes and Melvin, 2006) Structure/Composition of the Population Young people and old people spend a higher proportion of their income than those people in middle age (between 35-60 years old).this is because young people use their money to settle down, buy houses or get married. An economy with many middle aged people will have more savings than an economy with many young and old people. Middle aged people save more because they are looking forward to retirement. Old people eat their savings and pensions so they do not save a lot. (Anderton, 2008) Level of Consumption Income is usually divided into two parts; consumption and savings. This in a way means that all income that is not spent goes to savings. It follows that if the level of consumption in an economy increases, the level of savings in that economy will automatically decline. This fact is illustrated in the following equation; C + S = Y, where C = Consumption S = Savings Y = Disposable Income The above equation illustrates the fact that all disposable income is either consumed or saved. Consumption levels in an economy can therefore be said to be the biggest determinants of the levels of savings. (Gapinski, 1993). Marginal Propensity to save (MPS) is the proportion of an additional unit in disposable income that goes to savings. Marginal Propensity to consume (MPS) on the other hand is the proportion of an additional unit in disposable income that goes to consumption. The relationship between MPS and MPC is; MPS + MPC = 1, where MPS = ∆Y/∆S MPC = ∆Y/∆C Another different case is a situation where a family, having spent a lot of money in a consumption boom, tries to break its spending tendencies before they become unsustainable. (Bade and Parkin, 2006) The Level of Employment in the Economy A higher level of employment in an economy means most people are working and earning an income. This means that the aggregate income levels will increase as the rate of employment rises. When aggregate income in the economy increases, most households in that economy tend to have a higher disposable income. They will thus have enough to consume and save thus increasing the general savings level in the economy. (Walter, 2006) Availability of Credit in an Economy The government can choose to make credit easy or difficult to access depending on the result it wants to see in the economy. Making credit readily available will increase the amount of money that people can access thus the level of savings will tend to increase. An example of this is government regulations on credit like setting maximum loan repayment periods and minimum deposits. (Case and Fair, 2004) Conclusion There are many problems associated with low savings rates. An example is the fact that consumers have very little margin for error. Lower incomes or rising costs of living, would mean people have very little backup for emergency. It is not a coincidence that those countries with low saving ratios usually tend to have current account deficits in their budgets. (Baumol and Blinder, 2010) This is down to the fact that with low savings, there is relatively high spending on imported products. Very large current account deficits will increase the likelihood of currency devaluation in an economy e.g. the US dollar since year 2000 and also in Iceland. Also, a low saving ratio implies less investment in the economy. It reflects a choice in the people’s behaviour where they choose to have greater living standards today at the expense of the future. Reference list: Anderton, Alain (2008). Economics: As Level .Courseway. Bade, Robin and Parkin, Michael (2006). Essential foundations of economics. Addison- Wesley.p348 Baumol, William J and Blinder, Alan S. (2010). Macroeconomics: Principles and Policy. Cengage Learning.p129 Bernheim, B. Douglas and Shoven, John B. (1991). National saving and economic performance. National Bureau of Economic Research.p75 Boyes, William and Melvin, Michael. (2006). Economics. Cengage Learning.p217 Case, Karl E. and Fair, Ray C. (2004). Principles of Economics. Prentice Hall. Gapinski, James H. (1993).The Economics of Saving. Kluwer Academic Publishers.p236 Mankiw, N. Gregory (2008). Principles of Economics.Cengage Learning. p477 and p674 McRae, Hamish. (2011). SparkNotes: Measuring the Economy 1: Gross Domestic Product (GDP). Retrieved 6th May 2011 www.sparknotes.com/economics/macro/.../section1.html Schmidt-Hebbel, Klaus and Serven, Luis (1999).The economics of saving and growth:theory,evidence and implication for policy. Camridge University Press.p1 virtual.yosemite.cc.ca.us. (2011). GDP calculations Retrieved 6th May 2011. http://virtual.yosemite.cc.ca.us/rlamont/Aplia%20hints/gdp%20calculations.htm Read More