Research Discussion Paper – RDP 9512 Consumption, Investment and International Linkages Abstract

This paper seeks to explain the strong contemporaneous relationship between Australian and foreign output growth. It does so by adopting a more disaggregated approach than previous work, focussing in particular on consumption and investment. The theoretical frameworks of the permanent income hypothesis for consumption and the cash flow version of the neo-classical model of investment are used to identify potential foreign linkages. Some evidence of a foreign linkage through consumption is established. Little evidence is found of foreign influences on domestic investment, although an indirect channel operating through business confidence is identified. The paper also provides evidence of a decline in liquidity constraints since financial deregulation, and confirms previous evidence of the importance of cash flow in determining investment.

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