RDP 9512: Consumption, Investment and International Linkages 1. Introduction
December 1995
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The Australian economy is generally assumed to be strongly influenced by developments in the industrialised world economy and, in particular, the US economy. Gruen and Shuetrim (1994) document a strong contemporaneous correlation of 0.8 between quarterly Australian and OECD growth, but are unable to explain this finding. Hall and McTaggart (1993) estimate a coefficient on US growth of 0.5 in a model of Australian growth.[1] Obstfeld (1994) identifies similar strong correlations between the output growth of the G-7 countries (although on an annual basis).
One possible explanation for the correlation is that the oil shocks of the 1970s caused a synchronisation of the business cycles of the industrial countries, which has persisted over the last twenty years. However, this is unlikely, given the different policy responses to the second oil price shock, and the large number of idiosyncratic shocks that have occurred since, such as the different experiences under the ERM and German unification. Another possible linkage is through explicit or implicit policy coordination. For instance, there was a general shift in anti-inflationary preferences over the 1980s in most industrial countries, which may have resulted in similar monetary policy settings across countries. However, the common shift in policy preferences is unlikely to imply such a strong contemporaneous correlation. Furthermore, the timing of this shift in policy preferences varied considerably across countries. For example, Australia shifted to a tighter fiscal policy stance much in advance of the US, but brought inflation down to low single figures considerably later.
The purpose of this paper is to better understand the linkages behind the strong contemporaneous correlation by focusing on two components of Australian output – consumption and investment – to isolate the channels through which foreign developments affect the Australian economy.
In focusing on consumption and investment, we also update previous Bank work on the estimation of aggregate consumption and investment models. Our consumption equation updates the test of the permanent income hypothesis of McKibbin and Richards (1988) while our investment equation updates the cash-flow model of investment tested by McKibbin and Siegloff (1987). The two approaches are theoretically similar, relying on capital market imperfections: in the case of consumption, a fraction of consumers are assumed to be ‘rule-of-thumb’ consumers or liquidity constrained and thus fund their consumption from current rather than permanent income; in the case of investment, a fraction of firms are also liquidity constrained (or pay a premium on external funds) and hence fund their investment from current cash flow (profit) rather than borrowing or issuing equity against future streams of profit. Consequently, consumption and investment are ‘excessively sensitive’ to current income and cash flow respectively.
By using this framework we are able to determine if foreign variables provide a useful signal of permanent income (in the case of consumption) or future profitability (in the case of investment). That is, this approach tests whether foreign variables have a direct impact on consumption or investment controlling for their indirect effect through domestic output. We find some evidence of such a channel for consumption. The only channel of significance for investment that we identify is through business confidence.
As a byproduct of this approach, we also test the hypothesis that consumers have become less liquidity constrained as a result of the financial deregulation of the 1980s. The results suggest that this is indeed the case. The investment equations also confirm the findings of other studies that internal finance is an important determinant of business investment.[2]
The next section provides some summary information on the relationship between the Australian business cycle and foreign business cycles. Movements in levels as well as growth rates are considered. Section 3 presents the theoretical models that motivate our consumption and investment equations, while Section 4 presents the results of the estimation. Section 5 concludes.