Precautionary saving is saving (non-expenditure of a portion of income) that occurs in response to uncertainty regarding future income. The precautionary motive to delay consumption and save in the current period rises due to the lack of completeness of insurance 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. 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 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. This was realized by Friedman (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 with a convex marginal utility (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 on precautionary savings. Increased savings in the current period raises the expected value 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) 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 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 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.
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