Personal Savings as a Function of Permanent Income

Abstract

In this paper, a model to estimate personal savings is constructed using an estimate of permanent income. Traditional approaches to studying aggregate personal savings depend on many independent variables that serve as the determinants of personal saving. Because some of the determinants used in such approaches can be difficult to obtain, estimating aggregate saving in this manner can be time-consuming and arduous. Using an estimate of permanent income based on Friedman's Permanent Income Hypothesis (PIH), this paper creates a model to estimate personal savings and tests the model by examining the Marginal Propensity to Save (MPS) that is derived from it. Permanent income was estimated using a two-stage least squares (2SLS) method and aggregate personal savings is estimated using ordinary least squares (OLS). The empirical evidence reveals that savings estimates and marginal propensities to save are consistent with results obtained studies using conventional approaches except during periods in which a wealth effect occurs. During such periods, additional variables need to be added to the model to account for a wealth effect. This analysis therefore serves to further validate the PIH and shows that it can be applied to studying household savings as well as consumption.