Consumption, Income, and International Capital Market Integration
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

Abstract

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

I. Introduction

How integrated are international capital markets? This is clearly an important issue. By allowing countries to borrow and lend money efficiently, open capital markets can provide the same services across countries that they provide within a single economy, allowing more efficient use of funds for investment and improving the allocation of consumption over time. These gains, which are similar to those accruing to individuals from capital markets within a country, were the logic behind the general move toward international financial liberalization since the late 1970s (documented in OECD, 1987, and Mathieson and Rojas-Suarez, 1990).

While the potential gains from open international capital markets are clear, measuring the actual level of international capital mobility has proved to be more difficult. 2/ Amongst the main measures used in the literature are comparisons of onshore-offshore nominal interest rates and the correlation of saving and investment rates across countries. Tests involving nominal interest comparisons generally indicate a high degree of capital mobility, whilst those involving real rates and savings-investment relationships show relatively low levels.

This uncertainty has revived interest in alternative measures of the openness of international capital markets. One promising avenue, suggested by Obstfeld (1994), involves using consumption patterns across countries as a measure of capital mobility. The logic behind the test is that if capital markets are integrated consumers will be able to insulate themselves against idiosyncratic disturbances, and hence that consumption across individual countries should be highly correlated with the path of the aggregate across all countries. Using this approach, Obstfeld finds evidence that capital mobility across industrial countries has been rising over time, but that it is still less than perfect.

This paper extends this work on international consumption patterns. As well as looking at a larger set of countries, a somewhat different estimating equation is derived which takes explicit account of the possibility that part of local consumption depends upon local income. As well as making the results more robust with respect to this type of behavior, this specification also differentiates between two different reasons for capital market failure; excess sensitivity of consumption to local income, and low correlation between changes in home and external consumption adjusted for income. It is useful to distinguish between these two sources of failure, which are not separated in earlier tests, since they have very different implications as to the source of the capital market imperfection.

The plan of the paper is as follows. The next section provides an overview of some alternative tests of international capital mobility. Section III then describes the proposed test for capital mobility and compares our approach with that taken by Obstfeld. Section IV describes the data and presents a discussion of some estimation issues. Sections V and VI discuss result from the full data set, and the European Community (EC), respectively. 3/ Section VIII concludes.

II. Alternative Approaches to Measuring International Capital Mobility

Tests of the level of international capital mobility generally fall into two categories. The first type uses the behavior of interest rates to measure capital mobility. The cleanest of these tests involves a comparison of movements of nominal on-shore and off-shore interest rates for the same instrument and currency. The logic behind these tests is that if there are no barriers to capital mobility then these rates should move very closely together, in order to eliminate arbitrage opportunities. If, on the other hand, there are constraints to moving capital between the host country and the rest of the world, then the two interest rates will be able to diverge significantly. The results from these tests almost uniformly show that international capital markets are currently very integrated. 4/ In addition, they indicate that switches in regime such as the elimination of capital controls by the Thatcher government in the United Kingdom in 1979 lead, almost immediately, to a dramatic increase in capital mobility.

A second type of test, originally developed by Feldstein and Horioka (1980), measures capital mobility by using the correlation between saving and investment across countries. The logic behind this test is that if capital is fully mobile then there is no reason to expect higher saving in any particular country to be reflected in higher investment in that particular country. Rather, the total pool of world saving will be augmented, and this saving will then be used to finance the most efficient investment available across all countries. By contrast, if there are barriers to capital mobility then saving will tend to be used domestically, creating a correlation between saving and investment. Numerous studies have found a strong positive correlation between saving and investment across countries, which, using the Feldstein and Horioka approach, implies low international capital mobility.

Attempts to reconcile the Feldstein-Horioka results with those using nominal interest rates have generally focused on potential problems with the Feldstein and Horioka test. Some authors have criticized the implicit assumption that saving and investment are uncorrelated in a world of high international capital mobility by developing models in which saving and investment are highly correlated even in such a regime. 5/ Other authors have suggested that governments may have targeted the current account. Since the current account is equal to the difference between saving and investment, this could create an artificial correlation between saving and investment. 6/ Still others have suggested that the two tests measure different concepts. The onshore-offshore interest rate tests look at capital mobility between the large financial centers (New York, Tokyo, London etc), while the saving investment correlations look at the capital mobility between countries (the United States, Japan, and the United Kingdom). 7/

The implication from this last line of reasoning is that the two tests may be measuring different concepts of capital mobility: that based on interest differentials is a test of short term capital mobility, whilst that based on savings-investment correlations is concerned with more long-term capital movements. One difference is clear. While onshore-offshore interest rate comparisons focus on the behavior of nominal interest rates, saving and investment respond to real interest rates. Hence, the work on saving-investment correlations is probably more closely related to work on comparisons of real interest rates across countries (for example Gagnon and Unferth (1993) and Goodwin and Grennes (1994); see MacDonald and Taylor (1990) for a survey). Although this work has generally rejected the equalization of real interest rates, one significant problem with this line of enquiry has been that it requires the auxiliary assumption that ex ante purchasing power parity is expected to hold. Recent empirical work (see, inter alia, Abuaf and Jorion, 1990, and MacDonald, 1993) has cast doubt on the accuracy of this assumption, and hence the value of these tests.

The conflicting results from the different tests have revived interest in alternative approaches to measuring international capital mobility. In particular, Obstfeld (1994) suggested that consumption paths could be used as a measure capital mobility. 8/ The idea behind this test is that in a fully integrated world consumption paths across countries should move together, reflecting the desire of individuals to smooth consumption and hence maximize welfare. This approach, which is more fundamental than those discussed earlier, implies a definition of capital market integration in which real interest rates are equalized across countries.

Focusing on consumption has several attractive features. The underlying theory is stronger than that for saving-investment correlations. In addition, since consumption is the ultimate goal of economic activity, it is a more fundamental test of the effects of financial integration on economic welfare than either the saving-investment correlations or interest rate comparisons. Also, it appears unlikely that macroeconomic policy is directed at private nondurable consumption patterns in the way it may be at the current account. Finally, as discussed below, it also incorporates a test of real interest rate parity which does not require the assumption that ex ante purchasing parity is expected to hold.

III. Consumption Across Countries in a Financially Integrated Area

Within a financially integrated area consumers can use capital markets to smooth consumption in response to anticipated movements in income. 9/ As a result, consumption patterns across different countries should move in the same manner, except for the impact of unforseen shocks to income. To see this, consider the Euler equation characterization of optimal consumption behavior. As formulated by Hall (1978), this assumes that rational, forward-looking consumers maximize the expected value of lifetime utility, subject to an intertemporal budget constraint. This yields the equation:

Et-1(Ct/Ct-1)={β(1+Rt-1)}σ,(1)

where Ct is the consumption, Et-1 is the mathematical expectation conditional on the information available at t-1, β is a subjective discount factor, σ is the intertemporal elasticity of substitution, and Rt-1 is the real interest rate between t-1 and t. Using small letters to represent logarithms, this can be rewritten:

Δct=lnβ+σln(l+Rt-1)+ϵt,(1)

where the error ϵt is uncorrelated with information available in period t-1 or earlier.

In order to see how this can be used as a test of capital mobility, consider the behavior of consumption across different countries. The path of consumption across countries a, b, …,r is:

Δcat=lnβa+σln(l+Rat-l)+ϵat,Δcbt..=lnβb+σln(l+Rbt-1)+ϵbt,Δcrt=lnβr+σln(l+Rrt-1)+ϵrt,(2)

where equations (2) assume that each country has the same intertemporal elasticity of substitution. In these circumstances, the only reason for consumption paths to differ across countries (other than differences in discount rates) is if the expected real interest rate faced by consumers in different countries diverge.

Expected real interest rates are able to differ across countries with limited financial linkages. However, if capital markets are integrated in the sense used in this paper then expected real interest rates will be equal. In this case, except for differences in the discount rate, consumption growth should follow the same pattern across countries. Mathematically:

ΔcitΔcjt=ln(βi/βj)+ϵijt,(3)

for any two countries i and j, where ϵijt is equal to ϵitjt. Equation (3) implies that consumption across countries in a financially integrated area should follow a random walk, and can be seen as an inter-country version of Hall’s original consumption model. 10/ It can also be seen as a test of the level of insurance that capital markets provide for consumption. If such markets are complete, then consumption should vary with aggregate values but be unrelated to other factors. Cochrane (1991) and Mace (1991) both use versions of equation (3) to test the complete markets model of consumption using data on consumption by individuals.

Equation (3) assumes that the random walk model of consumption is an accurate representation of consumption behavior in countries i and j. However, this model has not performed well in formal tests. In particular, models which assume that some proportion of the change in consumption is associated with anticipated changes in income, such as that estimated by Campbell and Mankiw (1989, 1990), consistently reject the forward looking model. In these models consumption is divided into a proportion (1-λ) which is associated with forward looking consumers and a proportion λ which is associated with “rule of thumb” consumers who vary consumption in line with the change in their income. Aggregate consumption therefore equals:

Δct=λΔyt+(l-λ)(lnβ+σln(l+Rt))+ϵt,(4)

where yt is disposable income.

Equation (4) can be extended to the multi-country case. To see this rewrite (4) as an equation in the real interest rate:

σln(l+Rit)=(ΔcitλiΔyit(l-λi)lnβiϵit)./(l-λi)(4)

If capital markets are integrated across countries, so that in ex ante terms Rit=Rjt, this implies that for two countries i and j:

Δcit=(lnβi(l-λi)/(l-λj)lnβj)+λiΔyit+(l-λi)/(l-λj)Δcjtλj(l-λi)/(l-λj)Δyjt+ϵijt,(5)

where ϵijt is a function of the error terms in ϵi and ϵj. This is the basic estimating equation used in this paper. It states that, in a world of high capital mobility and rule of thumb consumers, growth of consumption in any one country is related to growth in home income and growth in foreign consumption and income. It is also a test of real interest rate parity which does not rely upon the assumption that purchasing power parity is expected to hold.

As written, equation (5) is a test of capital mobility between two countries, and could be used in that way. However, it is often more informative to derive a test of capital mobility between a particular country and the rest of the world. This is done in the empirical work by making ‘country’ j into the rest of the world. 11/

There is an important parameter constraint on the coefficients in equation (5). This is best seen by reparameterizing the equation as follows:

ΔcitΔcjt=αi+λiΔyit+tiΔcjt(λi+ti)Δyj+ϵijt,(5')

where ti is equal to (λj-λi)/(1-λj) and αi=lnβi-(1-λi)/(1-λj)lnβj. The model implies that the sum of the coefficients on home income, external consumption, and external income should equal zero. The importance of this constraint can be seen by considering the case where capital mobility is not high, and hence the ex ante real interest rate in country i, Rit, differs from that in the rest of the world. The error-in-variable bias caused by this inequality will cause the coefficients on foreign consumption and foreign income to be biased downwards. This, in turn, implies that the sum of the estimated coefficients on home income, foreign consumption and foreign income will be less than zero. 12/ Hence, the restriction that the sum of the coefficients on income and consumption is equal to zero is a test of the integration of capital markets across countries.

Equation (5) provides a tractable method of investigating the importance of both rule of thumb consumers and capital market integration on consumption across countries. Consider an unrestricted version of model:

ΔcitΔcjt=αi+β1Δyit+β2Δcjt+β3Δyj+ϵijt.(5'')

The coefficients on income can be used to test the importance of rule of thumb consumers, while a test of whether the sum of the coefficients on home income, foreign income, and foreign consumption is less than zero provides a test the degree of capital market integration with the rest of the world.

One disadvantage with equation (5’’) is that it includes several series which may be highly collinear. In particular, income growth at home and abroad are often highly correlated, which lowers the level of precision of the individual parameter estimates. Hence, results from a simplified version of equation (5’’), in which it is assumed that λij, are also reported. This implies the following estimation equation:

ΔcitΔcjt=αi+β1Δyit+β2Δcjtβ1(l+β2)Δyj+ϵijt.(5'')

In this model the sensitivity of consumption with respect to income is given by parameter β1, while the level of capital integration is measured by the amount to which parameter β2 differs from 0.

Differentiating between excess sensitivity of consumption to income and lack of capital market integration as reasons for the deviation of consumption from its optimal path is important because the two sources of failure imply very different underlying problems. If the failure is caused by excess sensitivity of consumption to income, this implies that consumers are not taking full advantage of local asset markets. Hence, this is a test of the degree to which local consumers have access to local capital markets. By contrast, if home consumption growth has a low correlation with external consumption growth even when taking into account the impact of excess sensitivity of consumption with respect to income, this implies that there is a low level of integration between national capital markets. This is a test of the integration of capital markets, where integration is defined as equalization of ex ante real interest rates. Hence, in testing international capital mobility, we differentiate imperfect access of consumers to national capital markets from imperfect integration between capital markets.

This approach can be compared with that taken in Obstfeld (1994), who uses an approach suggested by Mace (1991) to examine the degree of capital mobility using consumption across countries. He estimates the following regression:

Δcit=α+βΔcjt+ΨΔyit+ϵit(6)

where Cjt is consumption in the rest of the world and yit is a measure of domestic income which is used to control for the effect of domestic income on consumption. The restriction β=1 and Ψ=0 is then used as a test of capital mobility, with β=0 and Ψ=1 as the result expected under autarky.

Comparing equations (5’) and (6), the most important point to note is that equation (6) does not include the change in aggregate income, Δyj. To the extent that Δyj is positively correlated with Δyi and Δcj (as it generally will be) then the coefficients on domestic income and foreign consumption will be biased downwards. In addition, equation (5’) implies that, in the “face of rule of thumb” consumers, the coefficient on the growth in consumption in the rest of the world need not equal 1, as assumed in the Mace/Obstfeld formulation. Both considerations imply that the hypothesis β=1 and Ψ=0 is not a very powerful test of optimum consumption patterns. 13/

IV. Data and Estimation Issues

Annual data on real nondurable consumption and real household disposable income were collected from the OECD’s Annual National Accounts for 15 countries: Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, the Netherlands, the United Kingdom, and the United States of America. All seven of the major industrial countries are included in our data set, as are almost half of the other OECD countries. Hence, we believe that it provides a reasonable proxy for industrial countries as a whole. 14/

The data cover the period 1971 to 1989, which is the period of floating exchange rates after the breakup of the Bretton Woods fixed exchange rate system. 15/ Annual data were chosen because it generally has greater informational content than quarterly data (Shiller and Perron, 1985) and because it avoids the contamination introduced into forward consumption models by seasonal elements (Osborne, 1988). Nondurable consumption was used because the theory is concerned with the marginal utility derived from consumption. Durable goods provide utility over several years, making measured consumption a bad proxy for the marginal utility derived from their ownership.

It is clearly important to make the definition of consumption as consistent as possible across countries. Since official measures of nondurable consumption are not available in most of our countries we have constructed our own measure of non-durable consumption by collecting data on the individual components of consumption which most closely approximate nondurable consumption and, for any one country, used the sum of these items as our measure of non-durable consumption. Our most comprehensive measure of real non-durable consumption (at 1980 prices) includes consumer spending on clothing, education, food, medical care and services. This measure is available for Austria, Canada, Finland, France, Japan, U.K. and U.S. Consumption of services was not available for the remaining countries and we have therefore defined non-durable consumption for these countries to exclude this term.

Real personal disposable income (at 1980 prices) is defined as real income minus taxation for all countries except Denmark, Ireland, Italy, Luxembourg and Greece. 16/ For these countries a reliable taxation series is not available for the full sample period and we have therefore utilized the reported measure of real income. Both our real consumption and income measures have been divided by population to produce corresponding per capita measures. Consumption and income in the rest of the region was calculated by weighting indices together using OECD estimates of purchasing power parity GDPs in 1980.

Equations (5’’) and (5’’’) were estimated using Generalized Method of Moments (GMM). GMM is particularly appropriate in this case for several reasons. Liquidity constraint models of this type should be estimated using instrumental variable estimation (such as GMM) since disturbances to domestic income contains information about permanent income and is therefore correlated with consumption. In addition, because the data on consumption are time averages the model implies a first order moving average process in the error (Working, 1960); GMM techniques provide an adjustment for this effect, as well as being robust to heteroscedascity. 17/ Finally, GMM provides a direct test of the over-identifying restriction that the instruments are uncorrelated with the errors. 18/ Hence, GMM can be used to simultaneously test the importance of the parameters and the orthogonality of the errors to the instruments.

The choice of instruments is important for this type of model. 19/ Past changes in income should be useful in helping to predict future changes in consumption and income. In addition, since the consumption model underlying our approach is the permanent income model, it follows that current consumption will summarize agents’ information about the future path of income (Campbell, 1987), thus lagged values of the change in consumption should also be a useful predictor of changes in income. Finally, the permanent income model also implies that the ratio of consumption to income should also be useful in predicting future income (Campbell, 1987). An important limitation on the instrument set is that first lags are inadmissable as instruments because the time averaging of the consumption data induces a correlation between the change in consumption and its first lag. To preserve degrees of freedom in the estimation only second lags of the instruments were used. Accordingly, the instrument set contained the second lag of the growth in real consumption, real disposable income, and ratio of nondurable consumption to disposable income both for the home country and the rest of the world.

V. International Results

Table 1 reports the results from testing the importance of income and financial market integration for the 15 industrial countries in the data set. The first column reports a Wald test for the joint significance of the six instruments in explaining the behavior of consumption growth for the country relative to the rest of the ‘world’. 20/ Since the random walk consumption model in equation (3) implies that no prior information should be useful in predicting the relative growth of consumption across countries this is a test of the optimality of consumption growth across countries. The results indicate that the random walk model is rejected for 12 of the 15 countries in the sample. Generally, these rejections are decisive, in the sense that they occur at the 1 percent level of significance. The model is not rejected for the United States and Japan (the largest two countries in the sample) and Belgium. 21/

Table 1.

International Data: General Model

Δcit - Δcjt = αi + β1 Δyit + β2 Δcjt + β3 Δyj + ϵijt

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Notes: The estimation period is 1973-89. Standard errors (adjusted for heteroscedascity) are reported in parentheses. One or two asterisks indicates that the coefficient is significantly different from zero at the 5 or 1 percent significance level, respectively. The instruments were the second lags of home and external consumption growth, income growth, and the ratio of consumption to income (saving).

The second column of the table reports a test of the over-identifying restriction that the errors in equation (5’’) are orthogonal to the instruments. This indicates that the generalized model, which includes terms in home income, external consumption, and external income, is an adequate description of the data, in the sense that the errors from this equation are no longer significantly correlated with the instruments used in the estimation.

The next three columns report the coefficient estimates for the independent variables in the regressions. Although there is some variation across countries, most of the coefficients on home income (β1) have the expected positive sign, while those on external income (β3) generally have the expected negative sign. One or both of the coefficients on income are significant in 6 of the 15 regressions, indicating that consumption is excessively sensitive to income in Italy, Canada, Austria, Denmark, Finland and Greece.

The sum of the coefficients on home income, foreign income, and foreign consumption, (β1+β2+β3), together with inferred standard errors, are shown in the next column of the table. The sum is significantly different from zero in 6 countries (France, Italy, the Netherlands, Denmark, Greece, and Luxembourg), although in the case of Italy the sum of the coefficients is significantly positive rather than negative. Strikingly, all of the countries which reject this test of capital market integration are current members of the EC, although Greece only joined part of the way through the estimation period. Hence, these results indicate that integration in world capital markets appears to have been lower in the EC than in the rest of the world.

The last column in Table 1 reports a Wald test of the hypothesis that the effect of home income on home consumption is the same as the effect of external income on external consumption. This restriction is accepted in 11 of the 15 countries being studied. 22/ Accordingly, Table 2 reports the results from estimating equation (5’’’), the simplified version of the model where this restriction is imposed. The coefficient on income growth, which measures the importance of income in consumption, is now significant in 8 of the 15 countries; the United States, Italy, the United Kingdom, Canada, Austria, Denmark, Finland, and Ireland. The coefficient on external consumption, which measures the level of capital market integration, is also significant for 8 (very different) countries; Germany, France, Italy, the Netherlands, Denmark, Greece, Ireland, and Luxembourg.

The results in Tables 1 and 2 show a strong geographical pattern. Consumption is excessively sensitive to income in the Anglo-Saxon countries (the United States, United Kingdom, Canada, and Ireland), the non-EC European countries (Finland and Austria), but generally not in the continental EC countries (exceptions being Italy, and Denmark). By contrast, while capital markets appear to be well integrated outside of the EC, full integration is rejected for all of the EC countries except the United Kingdom and (quite marginally) Belgium. Hence, the world appears to be divided into two zones. The United Kingdom and countries outside of the EC appear to have national capital markets which are quite well integrated with the rest of the world, but, except for Japan, their consumption is excessively sensitive to income. Within the EC excess sensitivity to income is generally less important, however these countries do not appear to be highly integrated with capital markets in the rest of the world. The only country for which consumption appears to be close to its optimal path is Japan, the sole country from Asia within our sample.

VI. European Community

The results from the previous section indicate that, measured in terms of consumption behavior, most countries in the EC are not very well integrated into the world capital market. One possible explanation for this result is that there is an integrated capital market within the EC, but that this market is imperfectly connected to the rest of the world. To investigate this possibility the model for EC countries was re-estimated with the “rest of the world” limited to current members of the EC. 23/

There are a number of reasons for being particularly interested in results which focus on the EC. It contains a number of relatively homogeneous industrialized countries which have close economic links, and therefore a priori would be expected to have a high degree of capital mobility. On the other hand, many of its members also maintained capital controls over most of the estimation period. 24/ Finally, moves toward regional integration such as the single market program and plans for a single currency make it a particularly interesting to focus upon the existing level of economic integration.

Table 2.

International Data: Simplified Model

Δcit - Δcjt = αi + β1 Δyit + β2 Δcjt + β3 Δyj + ϵijt

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Notes: The estimation period is 1973-89. Standard errors (adjusted for heteroscedascity) are reported in parentheses. One or two asterisks indicates that the coefficient is significantly different from zero at the 5 or 1 percent significance level, respectively. The instruments were the second lags of home and external consumption growth, income growth, and the ratio of consumption to income (saving).

Tables 3 and 4, which have the same format as Tables 1 and 2, respectively, show the results from estimating the model for the 10 current members of the EC in our sample. 25/ The results from this more limited set of countries are very similar to those found using the wider set of countries. In particular, all of the EC countries which rejected the hypothesis that their capital markets were integrated using the original data and the simplified model do so again using the more limited set of countries. Hence, even when behavior is compared to the rest of the EC, consumption across these countries appears to be impeded by the lack of integration of capital markets. These results imply that recent moves to increase capital market integration within the EC, through such initiatives as the EC-wide single market program and moves towards a single currency, may well provide significant benefits in terms of intra-regional consumption patterns.

VII. Conclusions

This paper has explored the issue of income constraints and capital mobility using data on consumption across countries. A procedure for testing the optimality of the underlying consumption path across different countries, and for identifying if rejections were caused by excess sensitivity of consumption to income or by lack of correlation with consumption in the rest of the region, was proposed and executed. The importance of differentiating between these two underlying causes is that they identify very different reasons for the failure. If the failure is caused by excess sensitivity of consumption to income, this implies that the problem has to do with local access of individuals to capital markets. By contrast, if home consumption growth has a low correlation with external consumption growth this implies that the problem has to do with the integration of national capital markets, not with access to them.

The results indicate that Japan is the only industrialized country in the sample for which national consumption appears to be fully integrated with the rest of the world. For the other countries, however, the source of the failure varies. Within the EC, with the notable exception of the United Kingdom, the failure is almost universally associated with incomplete integration across national capital markets, although some countries also show evidence of excess sensitivity to local income. Furthermore, this is true whether the “rest of the world” is limited only to EC members or to the industrial countries as a whole. Greater integration of national capital markets caused by moves towards a single market and, possibly, a single currency, could therefore provide potentially significant gains in economic welfare by improving consumption patterns across the region. Capital markets appear to be well integrated in the rest of the sample, but, except in the case of Japan, consumption is too dependent on changes in local income. Hence, the failure of the test appears to be associated with incomplete access of individuals to local capital markets.

Table 3.

European Community: General Model

Δcit - Δcjt = αi + β1 Δyit + β2 Δcjt + β3 Δyj + ϵijt

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Notes: The estimation period is 1973-89. Standard errors (adjusted for heteroscedascity) are reported in parentheses. One or two asterisks indicates that the coefficient is significantly different from zero at the 5 or 1 percent significance level, respectively. The instruments were the second lags of home and external consumption growth, income growth, and the ratio of consumption to income (saving).
Table 4.

European Community: Simplified Model

Δcit - Δcjt = αi + β1 Δyit + β2 Δcjt + β3 Δyj + ϵijt

article image
Notes: The estimation period is 1973-89. Standard errors (adjusted for heteroscedascity) are reported in parentheses. One or two asterisks indicates that the coefficient is significantly different from zero at the 5 or 1 percent significance level, respectively. The instruments were the second lags of home and external consumption growth, income growth, and the ratio of consumption to income (saving).

These results using consumption to measure capital market integration can be compared with the wider literature on international capital market integration. Overall, the results from this approach are closer in spirit to those using saving-investment correlations than those using nominal interest rate differentials, at least over our estimation period (1973-89). Full capital market integration is rejected for many countries, and even in those countries where capital markets may be well-integrated consumption still appears almost always to deviate from its optimal path because of limited use of assets markets.

One lesson from this work appears to be that even if capital is mobile between money center banks, this is not enough to ensure full integration of consumption patterns, or even enough to ensure capital market integration between national capital markets. It is worth stressing that the tests implemented in this paper probably capture a different type of capital mobility than that contained in a comparison of the nominal interest rates set in financial centers. This paper uses a theory which is based on the behavior of consumers and annual data, and can therefore be seen as measuring the economic integration of real activity, whilst tests involving nominal differentials can be seen as tests of the integration of short-term capital markets. Given that the latter concept of capital mobility is likely more closely related to speculative behavior, the former concept is probably of more interest to those who are interested in economic ‘fundamentals’. It also helps to explain why Japan, which is the only country to have experienced a significant debt cycle over the period in the sense of having imported large amounts of capital to industrialize and then repaid it, is the only country in our sample to exhibit a high degree of capital mobility.

Finally, a note on directions for future research. One obvious extension would be to obtain data for the pre-1973 period, in order to investigate the impact of the break-up of the Bretton Woods exchange rate system on capital mobility. Another is to use higher frequency data, which would facilitate investigation of interesting subperiods within this more general sample. This might include the impact of the ERM and single market program within Europe, and the more general trend towards financial liberalization in the industrial countries since the late 1970s.

Consumption, Income, and International Capital Market Integration
Author: Mr. Ronald MacDonald and Mr. Tamim Bayoumi