CEJOR (2013) 21 (Suppl 1):S3S11

DOI 10.1007/s10100-012-0254-7
ORIGINAL PAPER

The short-run and long-run behaviour of personal

consumption in Croatia
Casni

Ksenija Dumicic Anita Ceh

Irena Palic

Published online: 11 July 2012

Springer-Verlag 2012

Abstract In this paper cointegration and error correction models are used to explore
the long run and short run behavior of personal consumption in Croatia as a function
of income, house prices and total credit to households. The results of the analysis
showed that income (approximated by net real wage), house price and total credits to households play an important role in determining personal consumption. Also,
lagged values of house prices showed significant impact on consumption, suggesting
house price persistence. The most likely factors driving the house price persistence
may include expectations and idiosyncratic institutional characteristics like illiquid
real estate markets, inadequate property rights protection, high transaction costs, and
underdeveloped financial instruments.
Keywords Personal consumption Income House prices
Total loans to households Vector error correction model
1 Introduction
As the increasing body of empirical work has shown, private consumption is often
the crucial driver of aggregate demand as well as of the real economic growth in
most European post-transition countries. Thus, studies of household decision about
consumption are very important for understanding these economies and Croatia is
not an exception. According to data presented by the Croatian Bureau of Statistics,
household consumption in Croatia in 2010 accounted for about 60 % of gross domestic product, so it is obvious that consumption has a significant impact on economic

Casni

K. Dumicic (B) A. C.
I. Palic
Faculty of Economics and Business, University of Zagreb, Zagreb, Croatia
e-mail: kdumicic@efzg.hr

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activity. Therefore, understanding the determinants of household consumption represents an important macroeconomic policy issue. This study models the short-run
and long-run behavior of personal consumption in Croatia from first quarter 2002 to
first quarter 2010 by applying vector error correction model. Concerning determinants
of personal consumption, income and total loans to households are included into the
model among variables that affect household consumption and saving decisions, which
is in line with economic theory and relevant empirical research (Corbo and Schmidt
Hebbel 1991; Dumicic and Cibari
c 2010; Hussein and Thirlwall 1999; Jappelli and
Pagano 1998; Loayza et al. 2000, etc.). Besides income and total loans to households,
changes in house prices, interest rates on housing credits and housing loans are also
included in the analysis in order to quantify the effect of housing market variables on
personal consumption. Our analysis is motivated by several well-known macroeconomic theories. According to Keynes consumption theory, personal consumption is
a function of current income including autonomous consumption:
C = c0 + c1 (Y T )

(1)

where C represents current consumption, Y is current income and T denotes taxes.

Therefore, Y T represents disposable income. Moreover, c0 is autonomous consumption, and c1 is the marginal propensity to consume. Keynes states that other
determinants of consumption cannot be covered qualitatively; therefore they are not
included in consumption function (Lovrincevic 2000). The classical economists before
Keynes thought that a higher interest rate leads to a reduction in consumption, however
Keynes did not think that the interest rate can even theoretically affect the savings.
He held that the effect of short-term interest rates on consumption is secondary and rel
atively unimportant (Cibari
c 2010). Fisher based his theory on consumer preferences,
and stated that change in real interest rates can either reduce or increase personal consumption. An increase in real interest rates increases the demand in the second period,
but in the first period could theoretically lead to a reduction as well as to an increase in
consumption (Mankiw 1997). Regarding consumption theories, it is important to note
that decisions about lifelong consumption are complex, since the individual should
take into consideration income, investment strategies, macroeconomic trends and risks
over a longer period of time. It is difficult for the average individual in such situation to be perfectly rational and in that sense to maximize the utility (Bernheim and
Scholz 1993). This paper is organized as follows: Sect. 2 presents the data and methods
applied. Section 3 presents the results of the empirical analysis and Sect. 4 presents
conclusions.
2 Data and methods
According to availability of data and existing literature that deals with modeling
personal consumption, for the purpose of empirical analysis in this paper the following
variables were chosen: household consumption, income (approximated by average net
nominal wages), house price, interest rate on housing credits, (total) loans to households and housing loans. The analysis is conducted using quarterly data ranging from

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Table 1 Data description and sources

Variable

Description

Source

Household consumption (PC)

Millions of national currency,

chain-linked volumes,
reference year 2000
Average net nominal wages
of the employees in legal
entities, in national currency
Average market prices per
square meter of dwellings,
in national currency, total
for Croatia
Derived using consumer
price index
Weighted averages
of monthly interest rates
in % on annual basis
Millions of national currency
on annual basis
Millions of national currency
on annual basis

Statistical Office of the

European Communities
(Eurostat)
Croatian Central Bureau
of Statistics

Wage (W)

House price (HP)

CPI deflator
Interest rate on housing credits (R)

Total loans to households (TC)

Housing loans (HC)

Real Estate Exchange

database

International Financial
Statistics
Croatian national bank

Croatian national bank

Croatian national bank

Quarterly data (20022010)

first quarter 2002 to fourth quarter 2010 of the original time series. Statistical software
EViews 7 was used in the analysis. All series were deflated using the Consumer price
index. The series were converted into logarithms and seasonally adjusted. In Table 1
data description and sources are given.
Although our analysis does not require numerous variables, there are several limitations related to the data availability. In order to conduct the analysis quarterly data
on consumption, income, house prices, interest rates on housing credits, total loans
to households and housing loans are required. Data on total aggregate consumption
are used, although in the empirical literature non-durable consumption series are also
used (see Lettau and Ludvigson 2004, for a discussion). Data availability constrains
us to use average net nominal wages, as a proxy for labor income which is an adequate
variable for this analysis as suggested by traditional permanent income hypothesis.
Other variables are chosen in order to investigate how and to what extent do housing
market variables affect personal consumption which is in line with existing empirical
work regarding the topic (Vizek 2010; Posedel and Vizek 2009, 2010) (Fig. 1).
It is obvious that income (approximated by net nominal wages, LW) is steady over
the whole analyzed period. Total credit (LTC) is characterized by a gradual growth
trend while house prices (LHP) are more or less persistent throughout the analyzed
period. Housing loans (LHC) follow a steady growth trend till first quarter 2006,
reaching its peak in the second quarter 2006, and then growing steadily until the
second quarter 2008 when they reach another peak, followed by steady growth till
the end of analyzed period. Interest rate on housing credits series (LR) show a sharp
fall from the beginning of the analyzed period till the third quarter 2005, followed
by a steady growth until the third quarter 2006 and then reaching its minimum in
the third quarter 2007, raising again and reaching its peak in the third quarter 2008.

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Fig. 1 Determinants of personal consumption in Croatia for the period Q1 2002Q1 2010 (logarithm scale)

Fig. 2 Real personal consumption in Croatia for the period Q1 2002Q12010 in million kuna (Source
Croatian Bureau of Statistics)

A sharp fall is noticeable in the last quarter of 2008, followed by another growth
trend till the fourth quarter 2009 and a sharp fall at the end of the analyzed period.
The dependent variablereal personal consumption (PC) is developed in Fig. 2. The
consumption follows a growth trend from first quarter 2001 to first quarter 2008. In
first quarter 2008 it reaches its peak and afterwards it continuously decreases up to
second quarter 2009 as a result of global financial crises. After one quarter of slight
recovery, it diminishes again up to first quarter 2010.
Financial crises can have a lasting effect on economic activity when reflecting the
unwinding of financial imbalances that funded real sector imbalances. Clearly, housing developments are integral to the crises that has gripped financial markets since
August 2007 and then escalated to a near complete paralysis of credit flows in late
2008 (Duca et al. 2010). There is a substantial number of contributing factors and

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S7

lessons to be learned from that crisis, far too many to review in this study.1 The main
goal of our research is to determine the relative importance of income, house price,
interest rate on housing credits, (total) loans to households and housing loans for
private consumption in Croatia. When modeling personal consumption cointegration
and error correction methods are usually the methods of choice. A substantial number
of alternative ways to analyze integration and cointegration of time series have been
proposed (see for instance Maddala and Kim 1998; Harris 1995). In order to determine
whether a long-term relationship exists between aggregate consumption on one side
and income, house price, interest rate on housing credits, (total) loans to households
and housing loans on the other side, the Johansen procedure is used (Johansen 1988,
1991). The necessary, but not sufficient condition for cointegration is that each of the
analyzed variables should be integrated of the same order or that all series should
contain a deterministic trend (Granger 1986). In that sense, before testing for cointegration, series of interest were tested for unit roots using the Augmented Dickey Fuller
test (critical values for ADF test were taken from MacKinnon 1996). The ADF test has
a nonstationarity as a null hypothesis i.e. the null hypothesis states that the variable
under investigation has a unit root. The results suggest that the presence of a unit root
for any of the variables included in the analysis may not be rejected. First differences
of the variables are found to be integrated of order zero I(0), i.e. the variables were
found to be non-stationary in levels, but they are stationary after first-differencing.
So, in our study we treat all the variables as I(1).2
For the purpose of analyzing the cointegration relationships among:logarithm of
net real wage (LW), logarithm of house prices (LHP) and logarithm of total loans to
households (LTC), we define the following unrestricted VAR model:
Z t =  Z t1 +

t1


i Z t1 + et

(2)

k=1

where: Z t = (L W, L H P, L T C) , i is the matrix of parameters, is 3 by r matrix

of cointegration vectors, is 3 by r matrix of the respective loadings of cointegration
vectors, where r denotes the number of cointegrating vectors of the system. et is a
vector of residuals of the system and k represents a lag length of the VAR model.
For the Johansen (1988, 1991) procedure, we use trace and max statistics with the
aim to identify the number of cointegrating vectors between the variables of interest.
In that sense, the trace statistic is used to tests the null hypothesis that the number of
(different) cointegrating vectors is less than or equal to r, where as the max statistic
tests the null hypothesis that the number of (different) cointegrating vectors is equal
to r against the alternative hypothesis that the number of cointegrating vectors is equal
to r + 1 (Bahovec and Erjavec 2009). After assessing the long-run relationships, the
next step of the analysis was to estimate an error-correction model of aggregate consumption. During the procedure, statistically insignificant terms were eliminated from
1 For more details, see for example: Acharya and Schnabl (2009), IMF (2009).
2 To save space the results of unit root tests are not shown here. However, they are available from the author

upon request.

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Table 2 Johansen cointegration

(LW, LHP, LTC)

p values in brackets; VAR

includes 3 lags. Lag length
chosen according to
Schwarz-Bayesian information
criterion (SBIC)
Sour ce Authors calculations

Rank

Eigen value

Trace test

0.897

96.432

50.044

(0.000)

(0.000)

46.388

39.726

1
2

0.836
0.207

Max test

(0.000)

(0.000)

6.662

5.102

(0.617)

(0.729)

Table 3 Long-run elasticities () and corresponding standard errors and t values (LW, LHP, LTC)
Variable

Constant

Net real wage-LW

House price-LHP

Total credit-LTC

Country

SE and t value

SE and t value

SE and t value

Croatia

0.51

0.018

(0.325)

0.695

(0.068)

0.024

(0.071)

[0.057]

[10.28]

[0.346]

Numbers in brackets denotes standard error and numbers in parentheses denote t-statistics
Source Authors calculations

the model. Lastly, we derived the final error-correction model, which had to satisfy all
standard diagnostic tests.

3 The results of the empirical analysis of personal consumption in Croatia

The first step in our empirical analysis was to test for the number of cointegrating
vectors in VAR using trace and max statistics. Trace and max statistics, presented in
Table 2 suggest that on 5 % significance level in the case of Croatia two cointegrating
vectors were found.
Before proceeding to error correction model estimation, it is useful to analyze the
long run elasticities of consumption expenditures with regards to income, house price
and (total) loans to households reported in Table 3. This table indicates which variables
are used in order to obtain a cointegrating relationship.
It is noticeable that private consumption forms a relationship with income, house
prices and total credit, although coefficients for net real wage (a proxy for income) and
total credit are not statistically significant. Long-run elasticities of private consumption with the respect to net real wages, house price and total credit have the expected
sign, with the largest value of standard error for net real wages. Table 4 summarizes
the results of error correction model. After excluding interest rates of housing credits
and housing loans from the initial model, the final error-correction model, satisfied
all diagnostic tests, and so it might be considered statistically acceptable. More precisely, according to serial correlation LM test on every usual level of significance
the null hypothesis of no serial correlations at lag order h is not rejected. According to residual normality test (orthogonalization Cholesky), the null hypothesis that
residuals are multivariate normal on every usual level of significance is not rejected.

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Table 4 Error-correction model of private consumptionsummary of estimation results

Explanatory variables

Estimate

SE

t value

Error-correction term (1)

0.217

0.045

4.806

Consumption (1)

0.932

0.206

4.528

Consumption (2)

0.244

0.196

1.246

Net real wage (1)

0.592

0.161

3.664

0.446

0.174

2.557

House price (1)

Net real wage (2)

0.144

0.032

4.529
2.639

House price (2)

0.074

0.028

Total credit (1)

0.468

0.106

4.412

Total credit (2)

0.242

0.094

2.569

Adj. R2

0.665

RSS

2.11 106

Normality test

0.651

The White heteroskedasticity test showed that the residuals were homoskedastic. As
we can see, the error correction term has a significant and negative influence on
personal consumption. Therefore, it might be concluded that it does not only have
statistically significant influence, but judging from its value, it is also important from
the economic point of view. The parameter of the error correction term indicates an
overall impact of 21.69 % adjustment every quarter. Lagged values of consumption
turn out significant which suggests that consumption persistence is present in Croatia.
Net real wage (a proxy for income) lagged values are significant as well. Income
is significant and correctly signed, which is in accordance with economic theory, so
it can be concluded that it is an important determinant of personal consumption in
Croatia, with elasticities of 0.6 and 0.45. As far as house price is concerned, lag values
are statistically significant and negatively signed, which is an argument in favour of
house price persistence and also it confirms the recent studies conducted for other
post-transitional economies (see for instance Vizek 2010; Posedel and Vizek 2009,
2010). In addition to house price persistence, the results of the error-correction model
also reveal the importance of total credit as a determinant of personal consumption,
with statistically significant lag values.

4 Concluding remarks
The aim of this article was to analyze the short-run and long-run behavior of personal
consumption in Croatia. The analysis showed that net real wage (which was used as a
proxy for income), house price and total credit to households play an important role in
determining personal consumption in Croatia. In addition to income, and total credit
to households, error-correction model estimates also suggest that lagged values of
house price are significant which is an argument in favour of house price persistence.
This finding is in line with earlier studies by Hort (1998), Lamont and Stein (1999),

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Annett (2005), Posedel and Vizek (2009, 2010), which also suggested that house price
behavior in Eastern and Western European countries was characterized by persistence.
It is difficult to determine precisely what residual information exists in lagged values of
house prices, the most likely factors driving the persistence may include expectations
and idiosyncratic institutional characteristics like illiquid real estate markets, inadequate property rights protection, high transaction costs, and underdeveloped financial
instruments (Vizek 2010).
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