Chapter 2 - Literature Review
2.1 The Precautionary Savings Theory
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2. Literature Review
This chapter is divided into three sections. The first two sections explain the two main theories used in this thesis: The Precautionary Saving Model and the Life-Cycle Hypothesis. Each of these sections contains their main postulates, empirical applications and results. The third section explain the treatment and the reasons of the adoption of each one of the indicators.
2.1 The Precautionary Savings Theory
Although varying in their explanations, both the classical Precautionary Savings Model and Life-Cycle Model predict that households tend to increase their savings (and thus, decrease their consumption) according to the greater income uncertainty (Carroll, 1994; Engen & Gruber, 2001; Meng, 2003; Modigliani & Cao, 2004).
Leland (1968) introduced the Precautionary Saving Theory to the world explaining that the “’Precautionary’ demand for saving usually is described as the extra saving caused by future income being random rather than determinate”, and argued that the function of savings is positively related to the function of uncertainty.
Sandmo (1970), in turn, contributed to the debate insisting that the reasons which lead someone to save more might vary due to uncertainty on the returns of investment and on the predictability of income.
In complement to it, empirical tests found that precautionary motives are decisive determinant of the households saving and consumption behavior (Chou, Liu, & Hammitt, 2003; Engen & Gruber, 2001) and that this effect is stronger over the less wealthy families, since prudence8 declines in wealthier families (Chou, Liu,
8 Define as “the sensitivity of precautionary saving to risk”
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& Hammitt, 2003; Pratt, 1964). As mentioned by Kimball (1990): “[…] if absolute prudence is increasing, labor income uncertainty will lower the marginal propensity to consume out of wealth at a given level of consumption”.
Most of the recent empirical studies related to precautionary savings understands Education, Health and Housing as the main and the most important consumptions/variables within a household; and that the variation of these variables, and not just the uncertainty of future incomes, could lead the households to save more/consume less.
Studying the relationship between the health and consumption, Chou, Liu, & Hammitt (2003) found that uncertainty over future expenses in health leads people to save more and added saying that the implementation of the National Health Insurance in Taiwan (NHI) had an impact of 8.6% - 13.7% on the savings, especially over those households with fewer savings. Furthermore, they suggest that
“NHI yields a larger welfare improvement, through consumption smoothing, for households with smaller saving”.
Meng (2003), studying China, says that after the State-Owned Companies Reforms, the health-care system was no long fully provided by the state, but it became a “two-tier system” in which the state and the families started to share all the costs of health-care, and thus, it might have impacted on the household consumption.
In concordance with their results, Barnett & Brooks (2010) also found that for every additional yuan spent by the government in the healthcare system, urban Chinese families would tend to increase their consumption by 2 yuan. They explain that, with the increase of the governmental expenditures, urban households
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spending of the Chinese households, in the second half of the 2000`s – at that time the government expenditure on health-care increased significantly. In contrast, the same research, did not find any relationship between governmental expending on education and household consumption9.Baldacci, et al. (2010), in turn, find that the high level of precautionary savings may be related to inadequate policies on “health, old-age, and the elevated private cost of higher education” – differently to the findings of Barnett & Brooks (2010) by looking from the perspective of governmental expenditures on Education.
For Baldacci, et al. (2010), the government’s social spending has a non-linear impact on household savings; and governmental spending on health-care has the largest negative impact on household savings. The effects of government social expending on education, could only be observed when the “individual social spending” is considered separately. In that sense, depending on the perspective, expenditure on education might have a different relationship with the APC, which could lead to different results.
With all that said, and considering that the governmental expenditure on health and on education (understanding the restrictions previously mentioned) has a positive impact over the consumption, then the following two hypotheses can be raised:
Hypothesis 1: The more households expend on health-care, the bigger the negative impact it has on the APC.
9 Their results were statistically insignificant, but they argue that it might be because the data available counted just for the elementary and primary school, and that for the families, the most significant spending in education happens at the university level.
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Hypothesis 2: The greater the expenditure per household on education, the larger its negative impact on the Average Propensity to Consume of the Households.
Another very important variable that might have a big impact over the household consumption is the housing factor, especially after the “massive privatization of the housing stock in China”. In 1980`s, the housing sector started to be reformed, and as a result, the official rent increased and occupants of government housing could then buy their own house so that, in 1999, the great majority of the household were already expecting to buy their own house (Meng, 2003).
In their work, Chamon & Prasad (2010) suggest that using simple regression calculations, they noticed that “savings driven by the motive of home ownership could account for about 3 percentage points of the increase in the household saving rate from 1995 to 2005” – which represents a great impact if the growth of the housing price since the real estate open-process is considered. At the beginning of 1990, only 17 percent of the households owned their own houses, and this proportion had increased to 86 percent, in 2009. Therefore, Chamon & Prasad (2010) affirm that the rise of the household saving rate can be in part explained by the massive privatization of the housing sector.
That said, then a third hypothesis related to the housing sector can be raised as:
Hypothesis 3: The bigger the rise in the rate “Housing Price/Total Income”, the bigger is its negative impact on the household Average Propensity to Consume (APC).
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In summary, according to the theories and the empirical findings, this research expects to find a strong relationship between the variation of housing price, the expending on education and health and the variation of the APC.