I = S = +Chapter 11 – Capital and Saving, page 1 of 9• capital fundamentalism:• according to capital fundamentalism, capital is the key to development• it was believed that after foreign aid helped western European countries recover afterWorld War II, it could be redirected to developing countries to assist their growth• however, capital fundamentalism is no longer a favored approach to development;more emphasis has been placed on human capital (health, education, etc.) andinstitutional capacity• capital is still important to development and is one of the main factors explaining thedifference in productivity between rich and poor countries; the inputs to production(land, natural resources, capital) increase worker productivity, but the amount of landand the endowment of natural resources are fixed – thus, only physical capital can beincreased to increase per worker output and per worker income• where do savings come from?• an economy can choose to either spend its income on consumption or to save itsincome – for example, a household can spend its income on consumer goods or save itsincome in the bank; the savings of the entire economy are channeled throughintermediaries (stock markets, banks, etc.) into investment (capital formation); in aneconomy total saving (the supply of capital) equals total investment (the demand forcapital); however, total domestic saving does not necessarily equal total domesticinvestment because part of the savings for investment could come from abroad• the taxonomy of savings (assumes total saving, S, equals total investment, I):I = S = S d + S fI = S = [S g + S p] + [S fo + S fp]I = S = [(S gb + S ge) + (S pc + S ph) ] + [S fo + (S fpd + S fpe)]Sd – domestic savingSf – foreign savingSg – government savingSp – private sector savingSfo – foreign official saving: includes loans from multilateral organizations (suchas the World Bank) and foreign governments (including those at concessionaryterms), official development assistance, and grantsSfp – foreign private saving: includes loans on commercial terms by banks andforeign direct investmentSgb – government budgetary saving: equals government revenue less governmentexpenditureSge – government enterprises’ saving: profits earned by firms owned by thegovernmentSpc – private corporate saving: saving by private firmsSph – private household savingSfpd – foreign private debt: commercial loans from abroadChapter 11 – Capital and Saving, page 2 of 9Sfpe – foreign private equity: direct private ownership of a firm by a foreigner or aforeign firm in the developing countrySfo (foreign official saving) Sfo (foreign official saving)Sf (foreign saving) +Sfpd (foreign private debt)Sfp (foreign private saving) +Sfpe (foreign private equity)I = S =+Sgb (government budgetary saving)Sg (government saving) +Sge (government enterprises’ saving)Sd (domestic saving) +Spc (private corporate saving)Sp (private sector saving) +Sph (private household saving)the most important source of saving in developing countries is private householdsaving; it is not the case that poor countries cannot afford to save for capital formation –some poor countries have a greater saving rate than some rich countries• there are 3 stylized facts about saving:1. in a given country at a given time, the saving rate (saving as a proportion of income,s = S/Y) at the household level increases with income (see the Keynesian modelbelow)2. in a given country, the saving rate does not rise as the country’s level of incomeincreases3. across different countries with different incomes, the saving rate does not varysystematically• page 394, table 11-3 – saving rates (S/GDP = S/Y):some poor countries have higher saving rates than richer countriesrich countries might not save a greater proportion of their income because they alsohave a higher expected standard of living; developed countries might have lowersaving rates than developing countries because at the same income level, the level ofconsumption is higher in the developed countryChapter 11 – Capital and Saving, page 3 of 9this data also undermines the argument that poor countries cannot save becausethey are too poor to save and must rely on foreign aid• there are 4 models of household saving:1. Keynesian model2. relative-income hypothesis3. permanent-income hypothesis4. class-saving hypothesis1. the Keynesian model of saving:this model considers a given country at a given point in time; according to this model,household consumption is a function of income:consumption D Asav. C(Y) B Econs. 45° C F I1 I2incomeon the 45° line, consumption equals to income at all incomes; the C(Y) curve plots thelevel of consumption at all incomesat a given income, the distance from the 45° line to the C(Y) curve is the savings and thedistance from the C(Y) curve to the x-axis is the consumption; to the left of theintersection of the 45° line and the C(Y) curve, consumption is higher than earnings andsaving is negative (the household must borrow or dissave); to the right of theintersection, saving is positiveas household income increases, saving increases both absolutely (DE > AB) and also as aproportion of total income (ACABDFDE>); thus, this model supports stylized fact 1this model predicts 1) as a country gets richer over time, it will save a larger proportionof its income (because it moves right along the C(Y) curve) and 2) at a given point intime, a richer country will have a higher saving rate than a poor country (because it isfurther right along the C(Y) curve); thus, this model does not support stylized facts 2and 3. Thus, something is lacking in the model, and needs to be supplied by anothermodel.2. the relative-income hypothesis (attributed to James Duesenberry):Chapter 11 – Capital and Saving, page 4 of 9this model is similar to the Keynesian model, except the C(Y) curve shifts up over time(at all levels of income, the level of consumption rises over time):consumption C(Y) 1990 C(Y) 1930 45°incomeas average income increases, the level of consumption rises and the saving rate does notincreasethe level of consumption might rise over time because people will try to “keep up withthe Joneses” – as people adjust to consumption standards, they are not willing to returnto their previous standard of living; thus, there are two determinants to currentconsumption: 1) income and 2) highest