7 - Consumption and liquidity constraints: does financial integration matter?

Summary

A basic intuition is that when people are forward-looking, they try to reduce the variability of consumption over their life-time, and so expanding the means by which they can smooth consumption over time should reduce the dependency of their consumption on current income. There is a range of factors which facilitate so-called ‘consumption smoothing’, and it is difficult to identify domestic and international financial factors separately. This chapter assesses the effect of domestic and international financial integration on consumption in selected economies in the east Asian and western Pacific region. It outlines a simple model of consumer choice under liquidity constraints with changing real interest rates and demographics which motivates tests for a statistically significant effect on consumption of a range of variables which proxy financial and non-financial liquidity constraints. ‘Consumption’ is defined as expenditure on non-durables.

In the first section, a model is constructed of the consumption of households based on intertemporal optimisation with demographic change and subject to liquidity constraints. In the next section, this model is used to motivate the estimating equation, taking into consideration aggregation over time, aggregation over heterogeneous households, selection of proxies for the liquidity constraint, and various definitions of consumption and income. In the third section, econometric issues are discussed and the results for a basic model often used in the literature and for a more fully specified model are presented and discussed.