RDP 9209: Financial Liberalisation and Consumption Behaviour 1. Introduction

The last ten to fifteen years have seen substantial deregulation in the financial sectors of most OECD economies. Early innovation in financial markets was motivated in part by the large incentives to circumvent official regulations. Subsequently, financial change has been facilitated by the progressive dismantling of these same regulations. While liberalisation policies have been motivated mainly by the desire to improve efficiency within the financial system, important implications for the functioning of the macro economy also arise.

One of these is the presumption that financial market liberalisation has eased liquidity constraints facing households and has therefore allowed consumption to be smoothed over time. If households have rational expectations and consume from permanent income (the RE-PIH hypothesis) then consumption can be shown to follow a random walk (see Hall (1978)). This model of consumption behaviour has been widely rejected in empirical tests, however. These rejections, based on the finding that consumption behaviour is excessively sensitive to current disposable income, are frequently attributed to the failure of one particular maintained hypothesis of the PIH, namely that individuals with access to perfect capital markets can borrow or lend at the same interest rate to smooth consumption over their lifespans. If financial liberalisation has rendered capital markets somewhat less imperfect, and if the above interpretation for the failure of the RE-PIH to be supported by the data is correct, we should observe that the sensitivity of consumption to current income has fallen over time and is lower in countries that deregulated earlier and more thoroughly.

In attempting to test this proposition, the interpretation of estimated sensitivity parameters is subject to some ambiguity. Several hypotheses, some maintained, underlie the random walk model of consumption, notably that households are not liquidity constrained and that they do not behave myopically. We attempt to determine which of these hypotheses has failed by exarnining the random walk model both across time and between countries.

The plan of the paper is as follows. Section 2 sets out the Hall model of consumption and discusses the reasons that have been offered for its rejection in empirical tests. Section 3 sets out modifications to the Hall model to reflect the fact that a certain proportion of households experience difficulties in borrowing against the collateral of future labour income, and hence may be unable to attain the optimal profile of consumption over time implied by the PIH. This section also reviews previous empirical work which used this model to interpret the importance of liquidity constraints. Difficulties experienced with previous econometric studies guide the approach adopted in Section 4, where a version of the standard model is used to test whether the sensitivity of consumption to income has declined in successive decades in countries where financial liberalisation has eased liquidity constraints over time. In Section 5, the importance of pooling to allow for cross-correlation of residuals between countries (thus permitting more efficient parameter estimates) is demonstrated. In Section 6, time-varying parameter estimates of countries that liberalised during the 1970s and 1980s are presented. Finally, some concluding remarks are made in Section 7.