Wednesday, May 9, 2007

Essay: Discuss the effects of a fall in the Savings ratio?

Essay Question: Discuss the effects of a fall in the Savings ratio?(30)

The savings ratio is the % of income that is saved not spent. A fall in the savings ratio implies that consumer spending is increasing, often this is financed through increased borrowing. For example, in the UK a fall in the savings ratio has been associated with an increase in equity withdrawal.

UK savings ratio is currently 3.7% In 1997 savings ratio was 10%

Effects of Fall in Savings Ratio

1. Higher levels of Consumption.

Therefore, it is expected that AD will increase. (consumption is 66% of AD, therefore it will be quite significant.)
The increase in AD will cause an increase in economic growth and lower unemployment. However, rising AD may cause inflation. Inflation will occur when growth is faster than the long run trend rate. This is now a potential problem in the UK; inflation has recently gone above the government's inflation target of 1-3%. Although other factors, such as; rising taxes and cost push factors have played a role, the increase in consumer spending is pushing up the underlying inflation rate.

2. Boom and Bust

A fall in the savings ratio is usually accompanied by a rise in confidence. It is the rise in confidence which encourages borrowing and consumers to run down savings. Therefore, there is always a danger that a falling savings ratio can be a precursor to a boom and bust situation. For example, the last time the savings ratio fell to this levels was in the late 1980s at the height of the Lawson boom [2], shortly after the economy went into recession. However, things were different in the early 1990s inflation was much higher (10% rather than 3%).

3. Economy more sensitive to interest rates.

With a fall in the savings ratio interest rate changes will have a bigger effect in reducing spending. This is because levels of borrowing are higher and therefore a rise in interest rates has a significant impact on increasing interest repayments. Also, higher rates will not be increasing incomes from savings as much.

Mortgage interest payments account for nearly 20% of homeowners disposable income, for first time buyers it is higher; therefore, any rise in interest rates could reduce spending significantly.

4. Balance of Payments.

With higher levels of consumer spending, there will be an increase in imports.Therefore this will lead to a deterioration in the current account. This has occured in the UK. The UK's current account deficit now accounts for 3.5% of GDP. UK consumers have a high marginal propensity to import; this means as incomes increase, a high % goes on imports. The current account deficit could put downward pressure on the exchange rate in the long term.


A fall in the savings ratio can increase economic growth, at least in the short term. However, the growth may be unsustainable, especially if interest rates rise in the near future. There is also a danger of increased consumption causing inflation. However, at the moment the MPC is looking very carefully at inflationary pressures, and interest rates could rise to reduce spending.

However, some people argue a fall in the savings ratio is not a problem, but, it is just a reflection of strong economy and booming housing market, which increases scope for equity withdrawal.

But if house price were to fall, it could be a real problem as many people would have negative equity.

[1] Savings Ratio Statistics at National Stats
[2] Savings Ratio 1998 Q3 4.%

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