Precautionary savings
Encyclopedia
Precautionary savings occurs in response to uncertainty regarding future income
. The precautionary motive to delay consumption
and save in the current period rises due to the lack of completeness of insurance
markets. Accordingly, individuals will not be able to insure against some bad state of the economy in the future. They anticipate that if this bad state is realized, they will earn lower income. To avoid future income fluctuations and smooth consumption
, they set aside a precautionary reserve, by consuming less in the current period, and resort to it in case the bad state is realized in the future.
. Moreover, Alfred Marshal stressed the importance of saving to secure against future risks: "The thriftlessness of early times was in great measure due to the want of security that those who made provision for the future would enjoy it".
Defining this concept, individuals save out of their current income to smooth the expected consumption stream over time. The impact of the precautionary savings is realized through its impact on current consumption, as individuals defer their current consumption to be able to maintain the utility level of consumption in the future if income drops.
Some examples of events that create the need for precautionary savings include health risk, business risk, unavoidable expenditures, and risk of labor income change, saving for retirement and child's education.
Precautionary savings are intimately associated with investments, if earnings are not used for purchasing commodities and services; there is a probability that the precautionary savings can be invested to generate fixed capital and achieve economic growth.
Precautionary saving is different from precautionary savings. The first is a perpetual function, or a flow variable quantity. Conversely, the later denotes the stock that is present at a single point of time. Precautionary savings can be therefore termed as a buffer that is created by the individuals to keep their consumption path to a certain level.
Higher precautionary savings level would reflect on higher wealth of an individual or a growth in net worth.
), norms of individuals’ income spending are determined accordingly, in order to maintain the extra utility gained from extra consumption spending constant across time.
This was realized by Friedman
(1957) and later by Ando and Modigliani
(1963) and Bewley (1977) in their seminal work on the permanent income hypothesis (PIH).
The relevance of life-cycle framework, therefore, builds on inter-temporal allocation of resources between the present and an uncertain future with the goal of maximizing utility. Rational individuals take sequential decisions to achieve a coherent and ‘stable’ future goal using currently available information.
Moreover, under this framework, individuals will have to discount the future with a subjective discount rate that is equal to the market’s interest rate, in order to rule out dis-savings for lack of patience. Hence, the analysis usually focuses on the fluctuations of consumption due to the precautionary motive for savings. Therefore in case of income fluctuations, individuals maintain the level of marginal utility of consumption constant across time by saving and dis-saving.
Weil (1993) proposed a simplistic multi-period model to analyze determinants of precautionary savings. Analytical findings confirmed the presence of a precautionary savings motive, that is positively correlated with income risk. More extensive research has been conducted in this area, and concrete evidence confirmed that the presence of precautionary motive for savings building within the permanent income hypothesis framework.
It was only recently that economists confirmed the early findings of Leland. Lusardi (1998) confirmed that intuitions derived from economic models without a precautionary motive could be seriously misleading, even with small uncertainty.
A more developed analytical framework would consider the impact of income risk and capital risk on precautionary savings. Increased savings in the current period raises the expected value
of future consumption. Hence the consumer reacts to increased income riskiness by raising level of saving.
Yet increases in saving will also increase the variability (variance
) of future consumption. This in turn gives rise to two conflicting tendencies of income and substitution effects. Higher capital risk makes the consumer less inclined to expose his resources to the possibility of future loss; this imposes a positive substitution effect on consumption (i.e. substitute acquiring capital in the current period with consuming in the future to avoid capital loss in the future due to capital risk). This is met with an opposite force, as higher riskiness makes it necessary to save more in order to protect oneself against very low levels of future consumption. This explains the negative income effect
on consumption.
A step forward was led by Kimball (1990) who defined the characteristic of "prudence". The measure of absolute prudence was defined as q =-U'"/U", and the index of relative prudence as p=-wU"'/U" (i.e. U is a utility function). The prudence index measures the intensity of the precautionary motive just as risk aversion measures the intensity of the desire for insurance.
An attempt to quantify the impact of idiosyncratic risk on savings was led by Aiyagari (1994). Insurance market incompleteness was introduced by assuming a large number of individuals who receive idiosyncratic labor income shocks that are uninsured. This model allows for the individuals’ time preference rate - to differ from the markets’ interest rate
. Findings of the model showed that lower variability of earnings exhibited lower savings rate. Also, savings rate where higher by a range of 7% to 14% as variability of earnings increases. These findings are of significance for social policy analysis.
The analysis also accounted for the case where market interest rate was higher than the subjective time preference, and provided evidence that individuals will postpone consumption and save by accumulating large stocks of assets. In case both rates were equal, given an anticipated shock to the labor income, rational individual would hold a large stock of assets to hedge for the income risk. The paper also proves analytically that when interest rate is lower than the time preference rat, individuals would accumulate savings.
Dardanoni (1991) proposed that high percentages of precautionary savings would simply be implausible, as most savings should come from the top percentiles of the income distribution; i.e., individuals who are not very likely to engage in precautionary saving.
More sensibly, Browning and Lusardi (1996) concluded, that based on empirical literature precautionary motive is important for some people at some times, it is unlikely to be so for most people. In other words, the heterogeneity of consumption/saving behavior of individuals in the economy makes it difficult to precisely quantify precautionary motive for saving.
Moreover, insuring industrial workers’ future incomes against workplace accident was used to test the effect of insurance on precautionary savings. This was conducted for 7000 households who did not or could not obtain complete insurance coverage against workplace accident risk, covering 1917-1919. Industrial workers at the time significantly reduced their saving and insurance consumption by approximately 25 percent when their expected post accident benefits increased.
Subsequent analysis from Kazarosian (1997), using data from the National Longitudinal Survey, has shown that a doubling of uncertainty increases the ratio of wealth to permanent income by 29%. In addition, surveys have shown that most Americans desire precautionary savings at 8% of total net worth and 20% of total financial wealth.
Ventura and Eisenhauer (2005) argue that the reason behind lack of consensus of empirical work on the magnitude of precautionary savings is due to the lack of suitable data, and of a good proxy for future income variability.
In the context of business cycles, Challe and Rogot (2010) showed that shocks to labor productivity affect firm’s incentives to create jobs and hence the expected duration of unemployment spells. When employed workers are imperfectly insured against the occurrence of such spells, they hoard assets for self-insurance purposes. Moreover, during times of recession the precautionary motive for holding wealth is strengthened, causing aggregate savings to rise and aggregate consumption to fall which in turn interprets the implications of shock propagation in the economy.
Not only do individuals accumulate reserves for precautionary purposes, but also sovereigns follow the same behavior. Saving rates of fast growing emerging economies have been rising over time, leading to surprising “upstream” flows of capital from developing to rich countries. Carroll and Jeanne (2009) developed a model to test the relationship between economic development, stock of savings and capital flows. The model was able to confirm the precautionary motive of sovereigns' accumulation of assets (ratio of net foreign assets to GDP) in response to risks of global imbalances.
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
. The precautionary motive to delay consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
and save in the current period rises due to the lack of completeness of insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
markets. Accordingly, individuals will not be able to insure against some bad state of the economy in the future. They anticipate that if this bad state is realized, they will earn lower income. To avoid future income fluctuations and smooth consumption
Consumption smoothing
Consumption smoothing is the economic concept used to express the desire of people for having a stable path of consumption.Since Milton Friedman's permanent income theory and Modigliani and Brumberg life-cycle model, the idea that agents prefer a stable path of consumption has been widely accepted...
, they set aside a precautionary reserve, by consuming less in the current period, and resort to it in case the bad state is realized in the future.
Basic concept
Economists have realized significance of precautionary savings long ago. Historically, the precautionary motive for saving has been recognized by economists since the time of John Maynard KeynesKeynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
. Moreover, Alfred Marshal stressed the importance of saving to secure against future risks: "The thriftlessness of early times was in great measure due to the want of security that those who made provision for the future would enjoy it".
Defining this concept, individuals save out of their current income to smooth the expected consumption stream over time. The impact of the precautionary savings is realized through its impact on current consumption, as individuals defer their current consumption to be able to maintain the utility level of consumption in the future if income drops.
Some examples of events that create the need for precautionary savings include health risk, business risk, unavoidable expenditures, and risk of labor income change, saving for retirement and child's education.
Precautionary savings are intimately associated with investments, if earnings are not used for purchasing commodities and services; there is a probability that the precautionary savings can be invested to generate fixed capital and achieve economic growth.
Precautionary saving is different from precautionary savings. The first is a perpetual function, or a flow variable quantity. Conversely, the later denotes the stock that is present at a single point of time. Precautionary savings can be therefore termed as a buffer that is created by the individuals to keep their consumption path to a certain level.
Higher precautionary savings level would reflect on higher wealth of an individual or a growth in net worth.
Precautionary savings and life cycle - Permanent Income Hypothesis
In this context, precautionary saving is determined when some level of utility of consumption is well defined. Once the individual identifies this level (known in economics as consumers’ utility maximization problemUtility maximization problem
In microeconomics, the utility maximization problem is the problem consumers face: "how should I spend my money in order to maximize my utility?" It is a type of optimal decision problem.-Basic setup:...
), norms of individuals’ income spending are determined accordingly, in order to maintain the extra utility gained from extra consumption spending constant across time.
This was realized by Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
(1957) and later by Ando and Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...
(1963) and Bewley (1977) in their seminal work on the permanent income hypothesis (PIH).
The relevance of life-cycle framework, therefore, builds on inter-temporal allocation of resources between the present and an uncertain future with the goal of maximizing utility. Rational individuals take sequential decisions to achieve a coherent and ‘stable’ future goal using currently available information.
Moreover, under this framework, individuals will have to discount the future with a subjective discount rate that is equal to the market’s interest rate, in order to rule out dis-savings for lack of patience. Hence, the analysis usually focuses on the fluctuations of consumption due to the precautionary motive for savings. Therefore in case of income fluctuations, individuals maintain the level of marginal utility of consumption constant across time by saving and dis-saving.
Weil (1993) proposed a simplistic multi-period model to analyze determinants of precautionary savings. Analytical findings confirmed the presence of a precautionary savings motive, that is positively correlated with income risk. More extensive research has been conducted in this area, and concrete evidence confirmed that the presence of precautionary motive for savings building within the permanent income hypothesis framework.
(i) Theoretical motivation
Leland (1968) introduced a simple analytical framework that builds on the prudence individuals towards risk. This is a concept that economists define as decreasing absolute risk aversion risk aversion with a convex utility function (U”’ >0). Leland proved that, even for small variations of future income, the precautionary demand for saving exists.It was only recently that economists confirmed the early findings of Leland. Lusardi (1998) confirmed that intuitions derived from economic models without a precautionary motive could be seriously misleading, even with small uncertainty.
A more developed analytical framework would consider the impact of income risk and capital risk on precautionary savings. Increased savings in the current period raises the expected value
Expected value
In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...
of future consumption. Hence the consumer reacts to increased income riskiness by raising level of saving.
Yet increases in saving will also increase the variability (variance
Variance
In probability theory and statistics, the variance is a measure of how far a set of numbers is spread out. It is one of several descriptors of a probability distribution, describing how far the numbers lie from the mean . In particular, the variance is one of the moments of a distribution...
) of future consumption. This in turn gives rise to two conflicting tendencies of income and substitution effects. Higher capital risk makes the consumer less inclined to expose his resources to the possibility of future loss; this imposes a positive substitution effect on consumption (i.e. substitute acquiring capital in the current period with consuming in the future to avoid capital loss in the future due to capital risk). This is met with an opposite force, as higher riskiness makes it necessary to save more in order to protect oneself against very low levels of future consumption. This explains the negative income effect
Income effect
In economics, the consumer's preferences, money income and prices play an important role in solving the consumer's optimization problem...
on consumption.
A step forward was led by Kimball (1990) who defined the characteristic of "prudence". The measure of absolute prudence was defined as q =-U'"/U", and the index of relative prudence as p=-wU"'/U" (i.e. U is a utility function). The prudence index measures the intensity of the precautionary motive just as risk aversion measures the intensity of the desire for insurance.
(ii) Empirical literature
The empirical literature shows mixed evidence on the significance of the precautionary motive for savings. Numerical simulations suggested the possibility precautionary saving, ranging from 20 to 60 percent of all saving. A significant empirical contribution by Brumberg (1956), showed that savings in the current period were seen statistically significant to bridge the gap between current income and the highest previously earned income. Hence, savings were considered a significant hedge against the income fluctuations.An attempt to quantify the impact of idiosyncratic risk on savings was led by Aiyagari (1994). Insurance market incompleteness was introduced by assuming a large number of individuals who receive idiosyncratic labor income shocks that are uninsured. This model allows for the individuals’ time preference rate - to differ from the markets’ interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
. Findings of the model showed that lower variability of earnings exhibited lower savings rate. Also, savings rate where higher by a range of 7% to 14% as variability of earnings increases. These findings are of significance for social policy analysis.
The analysis also accounted for the case where market interest rate was higher than the subjective time preference, and provided evidence that individuals will postpone consumption and save by accumulating large stocks of assets. In case both rates were equal, given an anticipated shock to the labor income, rational individual would hold a large stock of assets to hedge for the income risk. The paper also proves analytically that when interest rate is lower than the time preference rat, individuals would accumulate savings.
Dardanoni (1991) proposed that high percentages of precautionary savings would simply be implausible, as most savings should come from the top percentiles of the income distribution; i.e., individuals who are not very likely to engage in precautionary saving.
More sensibly, Browning and Lusardi (1996) concluded, that based on empirical literature precautionary motive is important for some people at some times, it is unlikely to be so for most people. In other words, the heterogeneity of consumption/saving behavior of individuals in the economy makes it difficult to precisely quantify precautionary motive for saving.
Moreover, insuring industrial workers’ future incomes against workplace accident was used to test the effect of insurance on precautionary savings. This was conducted for 7000 households who did not or could not obtain complete insurance coverage against workplace accident risk, covering 1917-1919. Industrial workers at the time significantly reduced their saving and insurance consumption by approximately 25 percent when their expected post accident benefits increased.
Subsequent analysis from Kazarosian (1997), using data from the National Longitudinal Survey, has shown that a doubling of uncertainty increases the ratio of wealth to permanent income by 29%. In addition, surveys have shown that most Americans desire precautionary savings at 8% of total net worth and 20% of total financial wealth.
Ventura and Eisenhauer (2005) argue that the reason behind lack of consensus of empirical work on the magnitude of precautionary savings is due to the lack of suitable data, and of a good proxy for future income variability.
Macroeconomic context
Empirical work has mostly focused on the representative individuals’ determinants of precautionary saving. More recent work emphasized on the importance of the time dimension. Under this notion, uncertainty about households anticipated future income due to expected unemployment, strengthens the precautionary motive for saving and hence and a cut in consumption spending (cetrus paribus). This in turn justifies the fact that precautionary savings may be part of the explanation why large consumption falls anticipate large increases in unemployment in response to exogenous shocks to the economy.In the context of business cycles, Challe and Rogot (2010) showed that shocks to labor productivity affect firm’s incentives to create jobs and hence the expected duration of unemployment spells. When employed workers are imperfectly insured against the occurrence of such spells, they hoard assets for self-insurance purposes. Moreover, during times of recession the precautionary motive for holding wealth is strengthened, causing aggregate savings to rise and aggregate consumption to fall which in turn interprets the implications of shock propagation in the economy.
Not only do individuals accumulate reserves for precautionary purposes, but also sovereigns follow the same behavior. Saving rates of fast growing emerging economies have been rising over time, leading to surprising “upstream” flows of capital from developing to rich countries. Carroll and Jeanne (2009) developed a model to test the relationship between economic development, stock of savings and capital flows. The model was able to confirm the precautionary motive of sovereigns' accumulation of assets (ratio of net foreign assets to GDP) in response to risks of global imbalances.
Further reading
- Caballero, Ricardo (1990): Consumption Puzzles and Precautionary Savings. Journal of Monetary Economics 25, 113-136.
- Cagetti, Marco (2003): Wealth Accumulation Over the Life Cycle and Precautionary Savings. Journal of Business & Economic Statistics, 21.
- Carroll, Christopher, and Kimball, Miles (2001): "Liquidity Constraints and Precautionary Saving"
- Carroll, Christopher, and Kimball, Miles (2006): "Precautionary Saving and Precautionary Wealth"
- Carroll, Christopher, and Samwick, Andrew (1996): "How Important Is Precautionary Saving?"
- Dustmann, Christian (1995): Return migration, uncertainty and precautionary savings. Development Journal of Development Economics, 52, 295-316.