StudySpace: Economics in Development, 6th Edition

Worked Example

1. This exercise examines components of saving and investment in Thailand, one of the world’s fastest-growing economies. Table 10–5 provides the necessary data.

Click here for Table 10-5

a.

(i) Calculate government savings (Sg), which is defined as government revenue less current expenditure. Fill in the first blank line of Table 10–5.

	1980	1990
Government Savings (Sg)

(ii) Calculate private savings (Sp), which is the difference between gross domestic savings and government savings. Fill in the second blank line of Table 10–5.

	1980	1990
Private Savings (Sp)

(iii) Calculate foreign savings (Sf), which is the difference between gross domestic investment and gross domestic savings. Fill in the third blank line of Table 10–5. (The negative of Sf is called the resource gap.)

	1980	1990
Foreign savings (Sf)

(iv) Finally, calculate private sector income (Ypriv) as the difference between GDP and tax payments to the government. Fill in the fourth blank line of Table 10–5.

	1980	1990
Private-sector income (Ypriv)

b. The marginal propensity to consume is defined as MPC = (change in consumption)/(change in income). In a similar manner the marginal propensity to save is defined as MPS = (change in savings)/(change in income). Since the change in income must equal the change in savings plus the change in consumption expenditure, the two marginal propensities are related by the formula MPS = 1 – MPC.

(i) For the period 1980 to 1990, the marginal propensity to save was

MPSgov = for the government sector,

MPSpriv = for the domestic private sector,

(ii) Given these figures for the MPS, a transfer of 10 billion baht from the private sector to the government sector would cause gross domestic savings to by billion baht. (Hint: The transfer of income will cause private-sector savings to fall and public-sector savings to rise.)

c.

Define the tax ratio as the ratio of government revenue to GDP.

(i) Thailand’s tax ratio went from percent in 1980 to percent in 1990.

(ii) The textbook says that the government’s MPC in most developing countries is so high (and the MPS so low) that a rise in the tax ratio reduces gross domestic savings. (This is the Please effect.) Is that what happened in Thailand?

d.

(i) In 1980, government capital expenditure exceeded government savings. How can the government capital outlays be larger than the amount of government savings out of revenue?

(ii) In 1990 the situation was reversed: Government savings exceeded government capital expenditure. What happens to government savings that is not channeled to government capital expenditure?

2. This exercise deals with some of the models of household saving behavior discussed in the textbook.

a. According to the Keynesian absolute-income hypothesis, savings is a simple function of disposable income. Let the savings function for the economy be

S = –100 + 0.5Y^d .

(i) Calculate savings (S) and the savings ratio (S/Y^d ) for the following levels of disposable income:

		S		S/Yd
Yd =	200				%
	300				%
	400				%

(ii) Is this simple savings function consistent with the observed tendency of S/Y to be roughly constant over time within a particular country? Explain.

b. According to the permanent-income hypothesis, current consumption depends primarily on permanent income, whereas a large fraction of transitory income is saved. To illustrate this hypothesis, let the savings function be

S = 0.167Yp + 0.5Yt

where Yt is the transitory component of current disposable income and Yp is permanent income. In this case one sixth of permanent income is saved and five sixths spent, whereas half of transitory income is saved. Over time, the transitory component averages out to zero.

(i) Suppose that households perceive that their permanent income is Yp = 300. Calculate S and S/Y^d for the following levels of disposable income:

The savings behavior should look familiar.

(ii) In the long run, households may adjust their perception of permanent income as they see actual income rise. As an example, suppose that households adjust their concept of permanent income to Yp = 400. With this adjustment, we find that S = when actual disposable income is Y^d = 400, and S/Y^d = percent.

(iii) Review the last two parts of the exercise. In the short run (when Yp is fixed at 300), we get S/Y^d = when Y^d equals 300 and S/Y^d = when Y d rises to 400. In the long run (after Yp adjusts), then S/Y^d = when Y^d equals 400.

c.

(i) Is the permanent-income model consistent with the observed tendency of S/Y to be roughly constant over time? Explain.

(ii) Is this model consistent with the fact that higher-income households tend to save a larger fraction of their income? Explain. (Hint: At any given time, the group of high-income households includes many with positive transitory incomes; the group of low-income households includes many with negative transitory incomes.)

(iii) Consider a country like Uganda, where the main product (coffee) is an export crop with a highly variable price in the world market. If household behavior conforms to the permanent-income hypothesis, how would the savings rate vary over time as coffee prices rise and fall? (Hint: What happens to transitory income as a percentage of total income?)

 

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