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IMF Working Paper Summaries (WP/95/1 - WP/95/61)
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Summary of WP/95/3: “Saving Behavior in Low- and Middle-Income Developing Countries: A Comparison”

Author(s):
International Monetary Fund
Published Date:
August 1995
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The responsiveness of saving to changes in real interest rates is a key parameter in the evaluation of the effects of a number of exogenous and policy-induced shocks in developing countries. Financial sector reforms have typically resulted in increases in real interest rates in developing countries, but the response of saving--and the effects on investment and growth--have been much less clear-cut. In addition, the effects on the external current account balance of fiscal policy changes that alter domestic interest rates depend on the responsiveness of private saving to movements in real rates of return. Finally, temporary terms of trade shocks or trade liberalizations that are not credible contribute to movements in consumption rates of interest (which measure the true cost of consuming today relative to consuming tomorrow) in developing countries, the effects of which on the current account depend critically on the elasticity of saving with respect to the real interest rate.

Empirical evidence suggests that the intertemporal elasticity of substitution in consumption (on which the interest rate elasticity of saving depends) varies considerably across developing countries. This paper argues that a main reason for this variation may be a country’s level of development. Specifically, because of the role of subsistence consumption in household expenditure, low-income developing countries will typically exhibit a negligible response of saving to movements in real interest rates, As the per capita income level rises, the fraction of the budget left after subsistence needs have been met increases. As only this fraction of the budget is sensitive to movements in real interest rates, the model implies a nonlinear relationship between the intertemporal elasticity of substitution and the level of development. The interest rate elasticity of saving should therefore be much higher in middle-income than in low-income countries (where it will be close to zero), but it will be only slightly higher in high-income than in middle-income countries, where subsistence plays little role in the expenditure patterns of most households.

These notions find support in the data. Using macroeconomic data from a sample of countries with diverse income levels, the paper concludes that a model in which the intertemporal elasticity of substitution is an increasing function of the gap between permanent income and the subsistence consumption level cannot be rejected. The model implies very different responses of private saving to {exogenous and policy-induced) real interest rate shocks, depending on the level of development.

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