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International Monetary Fund and University of Stratchclyde, respectively.
Recently the EC renamed itself as the European Union (EU). Since it was called the EC throughout the estimation period involved in this paper the original name will be used throughout.
Obstfeld (1989) and Tesar (1991). However, recent evidence indicates that saving and investment ratios within countries are generally uncorrelated. Since capital mobility within countries is high, this is consistent with the Feldstein and Horioka assumption (Bayoumi and Rose, 1993).
Individuals should also be able to smooth income in a world of full contingent markets. Atkeson and Bayoumi (1993) provide empirical estimates of the degree to which individuals actually use asset markets to smooth fluctuations in local income in the U.S. and EC.
Indeed, it has one advantage over the Hall formulation, in that it is not necessary to assume that the real interest rate is a constant over time in order to derive the result.
This also has the technical advantage that it minimizes the size of the error ϵj.
This can be seen most easily from equation (5). Since λj is less than 1 the sum of the coefficients on foreign consumption and income must be positive, hence any downward bias in the estimation must reduce the sum of the coefficients.
The OECD countries which are missing are Sweden, Norway, Iceland, Spain, Portugal, Australia, New Zealand, Switzerland, Turkey, and Yugoslavia. Of these, only Sweden, Switzerland and Australia have large economies.
These were the longest periods for which consistent data sets could be produced. In addition, the results in Obstfeld (1994) indicate that international consumption patterns during the Bretton Woods exchange rate regime are rather different from those during the subsequent floating rate regime.
The implicit deflator for total consumption was used to convert nominal into real income.
There is a well known problem with ensuring that the covariance matrix is positive definite. This was achieved using the procedure suggested by Newey and West (1987).
This is tested using the u “ZWZ” u statistic, which has a chi-squared distribution with degrees of freedom equal to the number of restrictions.
As discussed above, the six instruments were the second lags of the growth in real consumption, real income, and the ratio of consumption to income (the saving rate) for the country and the rest of the world. A constant term was also included in the regression, to take account of any deviation of the subjective discount rate across regions.
The fact that the instruments are good at predicting consumption is also important. Nelson and Startz (1990) discuss the problems with instrumental variables estimation when the instruments are poor predictors of the dependent variable.
The 4 countries which fail to accept this coefficient restriction all reject the optimality of underlying consumption through one or other of other of the tests discussed above.
Similar result were obtained when the sample was limited to long-term members of the EC (i.e., excluding the United Kingdom, Ireland, and Greece).
For example, France and Italy only removed their capital control at the end of 1990, as part of the single market program.
Spain and Portugal, which are also members of the EC, were excluded because of inadequate data.