Precautionary saving is

saving Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recur ...

(non-expenditure of a portion of

income Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. For ...

) that occurs in response to uncertainty regarding future income. The precautionary motive to delay

consumption Consumption may refer to: *Resource consumption *Tuberculosis, an infectious disease, historically * Consumption (ecology), receipt of energy by consuming other organisms * Consumption (economics), the purchasing of newly produced goods for curren ...

and save in the current period rises due to the lack of completeness of

insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...

markets. Accordingly, individuals will not be able to insure against some bad state of the economy in the future. They anticipate that if this bad state is realized, they will earn lower income. To avoid adverse effects of future income fluctuations and retain a smooth path of consumption, they set aside a precautionary reserve, called precautionary savings, by consuming less in the current period, and resort to it in case the bad state is realized in the future.

Basic concept

Economists have realized significance of precautionary saving long ago. Historically, the precautionary motive for saving has been recognized by economists since before the time of

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

. Moreover, Alfred Marshal stressed the importance of saving to secure against future risks: "The thriftlessness of early times was in great measure due to the want of security that those who made provision for the future would enjoy it". Defining this concept, individuals save out of their current income to smooth the expected consumption stream over time. The impact of the precautionary saving is realized through its impact on current consumption, as individuals defer their current consumption to be able to maintain the utility level of consumption in the future if income drops. Some examples of events that create the need for precautionary saving include health risk, business risk, unavoidable expenditures, and risk of labor income change, saving for retirement and a child's education. Precautionary savings are intimately associated with investments, if earnings are not used for purchasing commodities and services; there is a probability that the precautionary savings can be invested to generate fixed capital and achieve economic growth. Precautionary saving is different from precautionary savings. Saving is a flow variable quantity, measured in units of currency ''per unit of time'' (such as dollars per year). Conversely, the savings denotes the accumulated

stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...

of funds that is present at a single point of time. A higher rate of precautionary saving would lead to a higher growth in an individual's net worth.

Precautionary saving and life cycle: the Permanent Income Hypothesis

An individual's level of precautionary saving is modeled as being determined by the

utility maximization problem Utility maximization was first developed by utilitarian philosophers Jeremy Bentham and John Stuart Mill. In microeconomics, the utility maximization problem is the problem consumers face: "How should I spend my money in order to maximize my u ...

. This was realized by

Friedman Friedman, Friedmann, and Freedman are surnames of German origin, and from the 17th century were also adopted by Ashkenazi Jews. It is the 9th most common surname in Israel (8th among Jews) and most common exclusively Ashkenazi name. They may refer ...

(1957), and later by Ando and Modigliani (1963) and Bewley (1977) in their seminal work on the permanent income hypothesis (PIH). The relevance of the life-cycle framework, therefore, builds on intertemporal allocation of resources between the present and an uncertain future with the goal of maximizing utility. Rational individuals take sequential decisions to achieve a coherent and ‘stable’ future goal using currently available information. Weil (1993) proposed a simple multi-period model to analyze the determinants of precautionary saving. Analytical findings confirmed the presence of a precautionary saving motive, with precautionary saving positively correlated with income risk. More extensive research has confirmed the presence of a precautionary motive for saving within the permanent income hypothesis framework.

Uncertainty

Theoretical motivation

Leland (1968) introduced a simple analytical framework that builds on the prudence individuals towards risk. This is a concept that economists define as decreasing absolute risk aversion

risk aversion In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more ce ...

with a convex

marginal utility In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a Goods (economics), good or Service (economics), service describes how much pleasure or satisfaction is gained by consumers as a result o ...

(U"' >0). Leland proved that, even for small variations of future income, the precautionary demand for saving exists. It was only recently that economists confirmed the early findings of Leland. Lusardi (1998) confirmed that intuitions derived from economic models without a precautionary motive could be seriously misleading, even with small uncertainty. A more developed analytical framework would consider the impact of income risk and

capital risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

on precautionary savings. Increased savings in the current period raises the

expected value In probability theory, the expected value (also called expectation, expectancy, mathematical expectation, mean, average, or first moment) is a generalization of the weighted average. Informally, the expected value is the arithmetic mean of a l ...

of future consumption. Hence the consumer reacts to increased income riskiness by raising level of saving. Yet increases in saving will also increase the variability (

variance In probability theory and statistics, variance is the expectation of the squared deviation of a random variable from its population mean or sample mean. Variance is a measure of dispersion, meaning it is a measure of how far a set of numbers ...

) of future consumption. This in turn gives rise to two conflicting tendencies of income and substitution effects. Higher capital risk makes the consumer less inclined to expose his resources to the possibility of future loss; this imposes a positive

substitution effect In economics and particularly in consumer choice theory, the substitution effect is one component of the effect of a change in the price of a good upon the amount of that good demanded by a consumer, the other being the income effect. When a ...

on consumption (i.e. substitute acquiring capital in the current period with consuming in the future to avoid capital loss in the future due to capital risk). This is met with an opposite force, as higher riskiness makes it necessary to save more in order to protect oneself against very low levels of future consumption. This explains the negative

income effect The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their pref ...

on consumption. A step forward was led by Kimball (1990) who defined the characteristic of "prudence". The measure of absolute prudence was defined as q =-U'"/U", and the index of relative prudence as p=-wU"'/U" (i.e. U is a utility function). The prudence index measures the intensity of the precautionary motive just as risk aversion measures the intensity of the desire for insurance.

Empirical literature

The empirical literature shows mixed evidence on the significance of the precautionary motive for saving. Numerical simulations suggested the possibility precautionary saving, ranging from 20 to 60 percent of all saving. A significant empirical contribution by Brumberg (1956), showed that savings in the current period were seen statistically significant to bridge the gap between current income and the highest previously earned income. Hence, saving was considered a significant hedge against the income fluctuations. An attempt to quantify the impact of

idiosyncratic risk An idiosyncrasy is an unusual feature of a person (though there are also other uses, see below). It can also mean an odd habit. The term is often used to express eccentricity or peculiarity. A synonym may be "quirk". Etymology The term "idiosyncr ...

on saving was led by Aiyagari (1994). Insurance market incompleteness was introduced by assuming a large number of individuals who receive idiosyncratic labor income shocks that are uninsured. This model allows for the individuals’ time preference rate to differ from the markets’

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

. Findings of the model showed that lower variability of earnings led to a lower saving rate. Also, the saving rate became higher by a range of 7% to 14% as variability of earnings increased. The analysis also accounted for the case where market interest rate was higher than the subjective rate of time preference, and provided evidence that individuals will postpone consumption and save by accumulating large stocks of assets. When both rates were equal, given an anticipated shock to the labor income, a rational individual would hold a large stock of assets to hedge for the income risk. The paper also shows analytically that when the interest rate is lower than the time preference rate, individuals would accumulate savings. Dardanoni (1991) proposed that high rates of precautionary saving would simply be implausible, as most saving should come from the top percentiles of the income distribution—i.e., individuals who are not very likely to engage in precautionary saving. Browning and Lusardi (1996) concluded based on the empirical literature that while the precautionary motive is important for some people at some times, it is unlikely to be so for most people. In other words, the heterogeneity of consumption/saving behavior of individuals in the economy makes it difficult to precisely quantify the precautionary motive for saving. Moreover, insuring industrial workers’ future incomes against workplace accident was used to test the effect of insurance on precautionary savings. This was conducted for 7000 households who did not or could not obtain complete insurance coverage against workplace accident risk, covering 1917-1919. Industrial workers at the time significantly reduced their saving and insurance consumption by approximately 25 percent when their expected post accident benefits increased. Subsequent analysis from Kazarosian (1997), using data from the National Longitudinal Survey, has shown that a doubling of uncertainty increases the ratio of wealth to permanent income by 29%. In addition, surveys have shown that most Americans desire precautionary savings at 8% of total net worth and 20% of total financial wealth. Because of higher quality data on hours worked, a new literature considered precautionary labor supply, a part of precautionary savings. The findings support modest precautionary saving, which is particularly relevant for self-employed. If the self-employed faced the same wage risk as the civil servants, their hours of work would be reduced by 4.5%.

Macroeconomic context

Empirical work has mostly focused on the representative individual’s determinants of precautionary saving. More recent work focused on the importance of the time dimension. Under this notion, uncertainty about households' anticipated future income, due to expected unemployment, strengthens the precautionary motive for saving and hence holds down consumption spending (cetrus paribus). This in turn justifies the notion that precautionary saving may be part of the explanation of why large consumption falls anticipate large increases in unemployment in response to exogenous shocks to the economy. In the context of

business cycles Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by examini ...

, Challe and Ragot (2010) showed that shocks to labor productivity affect firms' incentives to create jobs and hence the expected duration of unemployment spells. When employed workers are imperfectly insured against the occurrence of such spells, they hoard assets for self-insurance purposes. Moreover, during times of recession the precautionary motive for holding wealth is strengthened, causing aggregate saving to rise and aggregate consumption to fall, which in turn affects the propagation of shocks in the economy. Not only do individuals accumulate reserves for precautionary purposes, but also sovereigns follow the same behavior. Saving rates of fast-growing emerging economies have been rising over time, leading to surprising “upstream” flows of capital from developing to rich countries. Carroll and Jeanne (2009) developed a model to test the relationship between economic development, the stock of savings and capital flows. The model was able to confirm the precautionary motive of sovereigns' accumulated assets (as a ratio to GDP) in response to risks of global imbalances.Carroll, C. and Jeanne, C. 2009.“A Tractable Model of Precautionary Reserves, Net Foreign Assets, or Sovereign Wealth Funds.” NBER Working Paper 15228, National Bureau of Economic Research, Inc