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TABLE OF CONTENTS

1.0 BACKGROUND.............................................................4

1.1 Introduction.......................................................................................4

1.2 Purpose of study...............................................................................7

1.3 Statement of the problem..................................................................8

1.4 Questions and issues........................................................................8

1.5 Overview of the paper.......................................................................9

2.0 LITERATURE REVIEW...............................................10

2.1 Introduction.....................................................................................10

2.2 The distinction between interest rates and returns:.........................10

2.3 Nominal versus Real Interest Rates:...................................................

2.4 Behaviour of Interest Rates:................................................................

2.5 Determinants of asset demand:......................................................13

2.5.1 The expected return from the asset:........................................13

2.5.2 Wealth:.........................................................................................

2.5.3 Risk (the degree of Uncertainty):..............................................14

2.5.4 Liquidity:...................................................................................14

2.6 Consumption.......................................................................................

2.6.1 The Absolute Income Hypothesis (AIH):..................................15

2.6.2 Life Cycle Hypothesis (LCH):...................................................16

2.6.3 Permanent Income Hypothesis (PIH):......................................17

2.6.4 Empirical Analysis....................................................................18


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2.6.5 Consumption: Durable vs non-durable.........................................

3.0 METHODOLOGY........................................................37

3.1 Introduction.....................................................................................37

3.2 Choice of subject............................................................................37

3.3 Research Approach........................................................................38

3.4 Method of Research........................................................................38

3.5 Research Strategy..........................................................................39

3.6 Research tool..................................................................................40

3.7 Choices of data collection...............................................................40

3.8 Time Horizons.................................................................................41

3.9 Sources of Data..............................................................................41

3.10 Key Variables..................................................................................42

3.10.1 Dependent Variable.................................................................42

3.10.2 Independent variable...............................................................43

3.11 Model Development........................................................................43

3.12 Value of study.................................................................................46

3.12.1 Reliability.................................................................................46

3.12.2 Validity.....................................................................................46

3.13 Result Expectation..........................................................................47

4.0 DATA ANALYSIS............................................................

4.1 Introduction.........................................................................................

4.2 The Empirical Results.........................................................................

4.3 The Relationship between Wage and Price........................................


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4.4 The Model...........................................................................................

4.5 The Empirical Results.........................................................................

4.6 Domestic Investment...........................................................................

4.7 The Model.......................................................................................67

4.8 The Empirical Results.........................................................................

5.0 CONCLUSION AND SUMMARY....................................

Conclusion and Summary


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CHAPTER ONE

10 BACKGROUND

1.1 Introduction

It is an undeniable truth that the development of an individual economy

passes through different economic phases. Sometimes it is booming and

sometimes it suffers from recession. In the theories, it may be possible to

have only the booming economy but the truth is truth. Theories are based on

the assumptions but the practical life has to move with time, in complex

environment, and the time is never static. A well known commentator of The

Independent laments that Europe is poorer than the United States in Gross

Domestic Product (GDP) per capita terms: ‘The UK is only barely catching up.

The rest is not only poorer but becoming even more poor’ (McRae, 2007). He

warns of a mass exodus of Europe’s best talent if this problem is not fixed

soon. His solution is to make Europe grow faster in order to prevent the ‘gap

in wealth’ from widening. This citation suggests that a nation’s Gross

Domestic Product is a measure of its total economic market output. As such,

it represents the lead indicator of the well-established system of economic

indicators. GDP is regarded as a technical term; however its importance has

long grown beyond its primary technical and scholarly functions. It has taken

on a much wider role as modern society’s main gauge of economic and,

almost by default, social progress. The fluctuation of GDP growth rate over

the period of 20 years from the year 1985 to 2005in the United Kingdom can

be seen in figure (1.1). This figure shows the dynamic nature of GDP.
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Source: Tradingeconomics; UK National Statist1

Figure (1.1) United Kingdom GDP growth rate

Consumer expenditure accounts in between 50% to 70% of GDP in most of

the economies and this accounts around 65% in UK. So, the private

consumption is regarded as an important factor for policy making. Since it

occupies the largest chunk of GDP, fluctuations in consumption has a

significant impact on GDP. Thus, the policy makers try to influence the

consumption at the time when there are some imbalances in the economy or

they want to change some saving issues. Individuals choose what to do with

their income. However, government can paly a vital influential role to alter the

consumption and saving behaviour of the individuals through different policies

such as saving taxes, expenditure taxes, investment taxes. Basically, the

household individuals have two choices to use their income; either they save

or they consume after paying the government tax. Since consumption

occupies a larger portion of income, a small change in consumption impacts

significantly on the saving. From a macroeconomic perspective,greater saving

is often advocated as a way of improvingeconomic performance.

One of the factors that influence the saving is the interest rate. Changes in

interest rate influences the consumption and saving in several ways.

Moreover, government uses interest rate as a monetary tool.


1 Downloaded from; http://www.tradingeconomics.com/Economics/GDP-
Growth.aspx?Symbol=GBP [Accessed on 23/02/11]
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Different countries use different economic policy to develop their country. The

UK has used inflation targeting economic policy. The UK central bank has

used interest rate as a primary tool to control the inflation rate. Since the

interest rate and the inflation rate tend to be inversely related. The probable

actions taken by the UK central bank to raise or lower the interest rate usually

(but not always) changes the inflation rate. During the time of cooled economy

interest rate can be lowered to accelerate the economy and raise the inflation.

Similarly, during the time of accelerated economy interest rate can be raised

to cool the economy and lower the inflation rate. To maintain the cooled and

accelerated condition of the economy the central bank has to change the

interest rate time to time. The figure (1.2) shows the fluctuation of interest rate

over the period of 20 years from 1985 to 2005.

The bar diagram was drawn from the UK central bank data.

Figure (1.2) Fluctuation of interest rate

This dissertation is a step towards understanding the relationship of changing

nature of interest rate with the consumption and the GDP in the United

Kingdom. The relationships of wages to inflation, the impact of currency

depreciation to consumption and investment have been empirically tested in

50 countries. In most countries, there is an evidence of the significant effect of

exchange rate on consumption and investment in the short run but not in the

long run. This is consistent with the expectation as wages do not adjust to

inflation in the short run but they do in the long run. The estimated results of

the consumption model have shown that the short-run effects last into the

long run only in 21 countries. Furthermore, while in nine countries the

coefficient estimate is positive supporting Alexander(1952)1952, in 13

countries it is negative, rejecting him. Considering the investment model, this

research found a significant short-run effect of currency depreciation on


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domestic investment in 43 out of 50 countries included in this study, implying

that the link between domestic investment and the exchange rate is

unavoidable. However, the short-run effects lasted into the long run only in 21

countries.

1.2 Purpose of study

There are hardly any economic papers which do not talk about the interest

rates. Perhaps, interest rates are the most closely watched element in the

financial market. “Interest rates are the most pervasive elements in the

financial world. They affect every nook and cranny of financial markets.”

(Ritter, Silber et al. 1991)Ritter, Silber et al. 1991. From this citation we can

say that how important is interest rate in an economy. A well known

commentator of The Independent laments that Europe is poorer than the

United States in GDP per capita terms: ‘The UK is only barely catching up.

The rest is not only poorer but becoming even more poor’ (McRae, 2007).

This statement shows the importance of the GDP. This dissertation has tried

to deal with some these issues such as the importance of interest rate, wage

and inflation, consumption and GDP.

1.3 Statement of the problem

It is an undeniable truth that the interest rate is an important factor in the

economy. Similarly, GDP is taken as an indicator of the progress of an

economy. Consumption occupies a largest chunk of the GDP. This means

these variables are interrelated in some complex way. There have been

numerous researches regarding these topics. Some researches have found a

positive relationship between interest rate and consumption

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PC9yZWNvcmQ+PC9D aXRlPjwvRW5kTm90ZT5= (Weber 1970; Weber

1971; Springer 1975; Elmendorf and System 1996; Horioka and Wan 2007;

Kapoor and Ravi 2009)Weber 1970Weber 1971Springer 1975Elmendorf and

System 1996Horioka and Wan 2007Kapoor and Ravi 2009. Similarly we can

find the researches which have found negative relationship between interest

rate and consumption

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9DaXRlPjwvRW5kTm90 ZT4A (Wright 1967; Feldstein and Tsiang 1968;

Mishkin 1976; Boskin 1978; Gylfason 1981; Summers 1981; Carlino 1982;

Summers 1984; Deaton 1992; Fetzer 1998)Wright 1967Feldstein and Tsiang

1968Mishkin 1976Boskin 1978Gylfason 1981Summers 1981Carlino

1982Summers 1984Deaton 1992Fetzer 1998. Meanwhile, we can see some

of the researchers who suggest that there is no significant relationship

between interest rate and consumption

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mQ+PC9DaXRlPjwvRW5k Tm90ZT4A (Keynes 1936; Poole 1972; Balassa

1989; Pourgerami and Ghouri 1991; Attanasio and Weber 1993; Fernandez-

Corugedo 2004; Keynes 2006; Heim 2009)Keynes 1936Poole 1972Balassa

1989Pourgerami and Ghouri 1991Attanasio and Weber 1993Fernandez-

Corugedo 2004Keynes 2006Heim 2009.

1.4 Questions and issues

The main issues which this dissertation is dealing with are the as follows:
59

➢ What is therelationship between wage and inflation, how the inflation

is related to the wage?

➢ What is the impact of currency depreciation impact on consumption

and investment?

➢ What is the role of interest rate on export and import?

➢ What is the relationship between interest rate and consumption?

1.1 Overview of the paper

This dissertation is divided into five sections. Section one introduces the topic

with some background of the UK economy. Section two describes the

literature reviews, which describes the past findings about the topic and the

views of the researchers who have made extensive research on the related

topics. Section three describes the methodology. Methodology it the detailed

explanation of how the research will be carried out. The explanation about he

types of research, types of data required, sources of data, development of

model are described on the methodology section. Section four deals with the

data collection and data analysis part of this dissertation, where require data

for the analysis is collected and analysed to reach the conclusion. Section five

is the section of conclusion, where the conclusion of the paper has been

presented. The overview of the paper can be presented in the work flow

diagram as shown in figure (1.3) below.

Data
Conclusion
Literature
Analysis
Methodolog
Introduction
&Rev
Sum
&F
60
61

CHAPTER TWO

20 LITERATURE REVIEW

2.1 Introduction

Interest rates are the most closely watched element in the financial market. It

drives the decision, whether to lend or borrow, save or invest or choose the

available alternative investment opportunities. Interest rates are the primary

tool to consider while making investments. “Interest rates are the most

pervasive elements in the financial world. They affect every nook and cranny

of financial markets” (Ritter, Silber et al. 1991)Ritter, Silber et al. 1991.

2.2 The distinction between interest rates and returns:

One important thing the investors must know is the distinction between

interest rates and returns. Many people think that the interest rate on a bond

tells them all they need to know about how well off they are as a result of

owing it. Interest rates provide a kind of return to the investor but it is not

necessarily the only one return to the investor. There is another term which

added to the interest rates to make return is called capital gain. The

combination of capital gain and the interest rates provides the return of an

investment. Algebraically, the return on a bond held from time t to time t + 1

can be written as

RET= C+Pt+1 - PtPt (2.1)

Where,

RET = return from holding the bond from time t to t+1

Pt = price of the bond at time t


62

Pt+1 = price of the bond at time t+1

C = Coupon payment

The above equation (5) can be rewritten in two separate terms which makes

thisformula easier to understand.

RET = CPt+ Pt+1- Pt Pt (2.2)

Here the first term is the current yield ic (the ratio between coupon payment

to purchase price)

C Pt= ic (2.3)

And the second term is known as rate of capital gain which is fractional

increase in price of the bond relative to purchase price.

Pt+1- PtPt=g (2.4)

Where g = rate of capital gain. Now the equation (2.2) can be rewritten as

RET = ic+ g (2.5)

The above equation (2.5) shows that return and interest rates are not same.

Interest rate is a part of return, and summation of interest rate and capital is

the return. Interest rates are more stable as compared to return since any

fluctuation in interest rate or capital gain causes return to fluctuate. Moreover,

capital gain fluctuates substantially due to the changes in price of the bond.

2.3 Nominal versus Real Interest Rates

So far in our discussion we have not considered the term inflation, an import

element for the economists. The interest rate without considering inflation is

known as nominal interest rates. This means nominal interest rates ignore the

effect of inflation. This means we are ignoring the purchasing power of money

rather talking only about the increment in dollars as a per cent of dollars

borrowed or loaned out. When we consider the effect of inflation in the

interest rate it is called real interest rate. “The real interest rate measures the
63

increment in purchasing power as a per cent of purchasing power loaned out”

(Ritter, Silber et al. 1991)Ritter, Silber et al. 1991. The relationship among

nominal interest rate, real interest rate and inflation is defined by the Fisher

equation, named for Irving Fisher, one of the great monetary economists of

the twentieth century. “The Fisher equation states that the nominal interest

rate i equals the real interest rate ir, plus the expected rate of inflation πe”

(Howells and Bain 2008)Howells and Bain 2008.

i= ir+πe (2.6)

Rearranging the above equation, we get

ir= i-πe (2.7)

From this equation we find that the real interest rate equals the nominal

interest rate minus the expected inflation rate. When the inflation is higher, the

real interest rate is lower. That is the purchasing power of money in terms of

goods and services is decreasing with the increase in inflation. For example, if

we make a load with 10% interest and the inflation is 5%. In real terms, by the

next year, we will be better off only by 5% in terms of goods and services,

because by the next year the prices of goods and services will be higher by

5% so the net worth is only 5%. At the time when the inflation is high people

are willing to borrow and invest in goods and services but unwilling to lend.

2.4 Behaviour of Interest Rates

Interest rates are one of the most closely watched elements in the financial

market. The fluctuations in the interest rates affect peoples’ lending and

borrowing decisions, investment and saving decisions, buying bonds or

stocks decisions. To understand the fluctuating behaviour of the interest rates

we need to analyse supply and demand of bonds and money in the markets.

This phenomenon is explained by a theory called ‘theory of asset demand’.

This theory deals with the decision making such as when to buy an asset,
64

what kind of asset to buy, when the market equilibrium occurs and how the

decision on holding different assets affect the interests rates. Here, we

assume that people can hold their assets in two ways, one as money and

another as bonds. Before dealing with the interest rates and assets demand,

we need to know about the determinants of assets demands.

2.5 Determinants of asset demand

An asset is a piece of paper that is a store of value. There are some factors

which affects the demand of assets, which are as follows.

The expected return from the asset

Assets provide returns to the investors so the investors choose to hold

those assets which provide more income relative to available

alternative assets. If company ABC bond, for example, provides 10%

return and if the expected return on it rises compared to other

available alternative assets, holding everything else constant, it is

more desirable to hold it relative to other assets. Similarly, if the

expected return on company XYZ bond falls while the expected return

from company ABC bond remains unchanged then it is more desirable

to hold company ABC bond. To sum, we can say that, holding,

everything else constant, an increase in expected return from an

asset, relative to available alternative assets, raises the quantity

demanded of the asset.

2.5.1 Wealth

Wealth is another factor which drives the demand of assets up and

down. Wealth is the assets and the resources that individuals hold.

When individuals are wealthy they can afford more and desire to hold

more assets. Thus, an increase in wealth, holding everything else

constant, raises the quantity demanded of an asset.


65

2.5.2 Risk (the degree of Uncertainty)

As the risk associated with an asset increases, it is less certain about

the expected return from that asset so it is less desirable to hold that

asset. Because of the risk aversion nature of the individuals, as the

risk associated with an asset increases relative to available alternative

assets, holding everything else constant, the quantity demanded of an

asset will fall.

Liquidity

The term liquidity is associated with conversion time and transaction

costs. Transaction cost is the cost incurred while converting an asset

into cash or any other asset. Liquidity of an asset is determined by

how quickly and with less transaction cost it can be converted to cash

or any other assets. Thus, the more the asset is liquid the more

desirable is to hold it. To sum up, we can say, holding everything

constant, the more liquid an asset is relative to available alternative

assets, greater will be the quantity demanded.

2.6 Consumption

Consumption, one of the most widely studied topics in the field of economics,

occupies 50% to 70% of gross domestic product (GDP) in most of the

countries. Since it occupies the largest chunk of GDP, it is an important

variable for the policy makers. There have been lots of studies about

aggregate consumption and still many scholars and researchers are carrying

out modern research in this topic. However, the results do not coincide at the

same conclusion. The relationship between interest rate and consumption

exists in a complex environment of macroeconomic variables. Such a

complex environment makes it difficult to find the precise effects of interest

rates on consumption. So to measure a precise impact of interest rates on


66

consumption it is required to isolate consumption decision from other

confusing factors.

However, there are lots of modern researches about the consumption, most

of the studies are based to varying degree on at least on of the three

fundamental models;(Keynes 1936)Keynes 1936 absolute income hypothesis

(AIH), Modigliani’s (1953) life cycle hypothesis (LCH) and Friedman’s (1957)

permanent income hypothesis (PIH).

2.6.1 The Absolute Income Hypothesis (AIH)

An important theory in the field of behavioural macroeconomics, Absolute

Income Hypothesis (AIH), was proposed by a famous English economist John

Maynard Keynes (1883-1946) in 1936. The theory examines the relationship

between income and consumption. He asserts that consumption was a stable,

but not necessarily linear, function of disposable income (after tax income).

The relationship can be expressed as;

Ct= α + βyt (2.8)

Where,

Ct = total consumption

α = autonomous component of consumption

β = the marginal propensity to consume

yt = total disposable income

According to Keynes autonomous component of consumption (α) is small but

positive and the marginal propensity to consume (β) is a small positive

fraction. In Keynes model the marginal propensity to consume determines the

change in consumption in response to a change in disposable income. This

model has been successful in modelling household consumption in short term

but has been less successful while applying over a longer time frame. This

model demonstrated that the fluctuation in interest rate has no significant

effect on consumption. However, he has acknowledged that substantial


67

changes in interest could have significant influence upon the marginal

propensity to consume but he did not mention the types of effect.

2.6.2 Life Cycle Hypothesis (LCH)

Life cycle hypothesis considers forward looking consumers’ behaviour. This

model was introduced in 1954 by the economists Albert Ando, Roy Harrod,

Irving Fisher and Franco Modigliani. Unlike, Keynes’s absolute income

hypothesis it assumes that consumers consume a constant percentage of the

present value of their life time income. The individuals’ consumption is

affected by the future expected income. When individuals are on their earning

age they do not consume whatever they earn at that time, rather they save

some portionof their income to finance consumption at their retirement age.

According to this model, individuals’ propensity to consume is high at the

early and old age and low at the middle age. In the LCH model consumers

maximize utility subject to the lifetime resources available to them. So,

according to this model the interest rate bears an important role in estimate

the expected future earning and net worth and which in turn influenced the

consumption.The model can be expressed by the equation.

Ct= α1yt+ α2yte+ α3At-1 (2.9)

Where,

Ct = total consumption

yt = current non-property income

At-1 = net worth at the time of t-1

yte = expected annual non-property income

Α = marginal propensity to consume our of income and asset

2.6.3 Permanent Income Hypothesis (PIH)

Another important consumption model in the field of economics, after Keynes

(AIH, 1936), was developed by the American economist Milton Friedman in

1957; the permanent income hypothesis (PIH). The PIH is considered as an


68

important theory in consumption behaviour. This model considers the forward

looking behaviour of consumers. It states that the choices made by the

individuals regarding their consumption patterns are not dependent on current

income; rather they are dependent on longer term income expectations. The

PIH model can be expressed by the expression

Cp=kr,w,u×yp (2.10)

C=Ct+Cp (2.11)

y=yt+yp (2.12)

Where,

y = total income

yt = transitory income

yp = permanent income

C = total consumption

Ct = transitory consumption

Cp = permanent consumption

k = permanent consumption function variable with the

arguments r, w and u

r = rate of interest

w = ratio of wealth to income

u = variable to indicate consumers’ taste

According to this expression, both income and consumption have two

components transitory component and permanent component. The transitory

component represents the unexpected income and expenditure and the

permanent component represents the anticipated and planned elements of

income and consumption. However, permanent component of both income

and consumption plays vital role to determine the consumption. He found


69

interest rate to be a major component to determine the marginal propensity to

consume out of permanent income(Fernandez-Corugedo and Studies

2004)Fernandez-Corugedo and Studies 2004.

2.6.4 Empirical Analysis

The empirical test of the effect of interest rate on aggregate consumption

carried our by Warren E. Weber have found that interest rates do significantly

affect aggregate consumption. He has found positive relationship between

interest rate and consumption in long run. The researcher has used more that

one interest rate to make sure of independence of choice of interest rates in

the test. He found that an increase in interest rate increases aggregate

consumption, assuming all things is held constant. The consumption function

was derived with the assumption of utility maximization behaviour of

individuals over a longer horizon and the test was performed with the data of

the United States for the period 1930-65. The empirical test was carried out at

the 0.001 level of significance for more than one interest rate (Weber

1970)Weber 1970.However, Weber conducted the same research after one

year, to test whether the effect of interest rate fluctuation in consumption in

short run is consistent with the long run result, with the quarterly data in 1971.

This time he used a single interest rate instead of using interest rate series

and found that only the corporate bond interest rates play and important role

in individuals’ consumption pattern (Weber 1971)Weber 1971. A similar result

with significant positive effect of change in interest rate on consumption was

found in his own 1975 paper (Weber 1975)Weber 1975 and by Springer

(1975)1975.

A recent study that is close to this research is the empirical test of the effect of

interest rate on household consumption under taken by MuditKapoor and

Shamika Ravi in 2009.This research was carried out after the change in

Indian banking legislation that offered higher interest rate on the deposits of
70

senior citizens (above sixty years). The banking legislation was established in

the year 2001. This change in banking legislation in Indian provided an

opportunity to find the relationship between interest rate and consumption

more accurately. The author used the household consumption expenditure

data from the National Sample Survey (NSS). The estimation of effect of

change in interest rate on consumption was done through comparing the

expenditures of households that are not eligible for the higher interest

earnings on their deposits to households that are eligible. The eligibility

criteria were based upon the age of the household members. When there is at

least one member who is sixty years or above was eligible for the higher

interest rate.The study has found a strong and significant short run impact on

saving and consumption of households. But it failed to explain the long term

effect due to the lack of sufficient data to explain the long term effect of

interest rate.They found an immediate 12 percent decline in household

consumption when the interest rates on deposits were increased by 50 basis

points. The effect was primarily in non-food, non-essential items which were

declined by 17 percent.The analysis was performed with the 2005-06 data.

And to compare the results with prior to banking legislation, 2000-01 data was

used (Kapoor and Ravi 2009)Kapoor and Ravi 2009.

A survey carried out by Elmendorf, member of Federal Reserve Board,

examines the change in interest rate and its effect on individuals’

consumption and saving who follow the life cycle model. According to life

cycle model people set a target and to reach that target they save. They

consider short planning horizons and plan to leave legacy for next generation.

This survey was concentrated on household consumption and saving with the

relation to change in interest rate in short run. The surveyor produced two fold

conclusions. First, he states that despite of large volume of studies, the result

of this topic, long rum, is not clear. Probably because individual research
71

represents the behaviour of some group of people and it is not clear about the

model which best describe the average consumer. Moreover, the researcher

claims that individuals might react to the change in interest rate in different

ways other than estimated by the existing models depending upon the nature

of liabilities and assets they hold. Thus the researcher finds it very difficult to

give a precise estimate of the effect of change in interest rate on consumption

and saving with any confidence. Second, the survey finds a positive

relationship between interest rate and consumption in short run. The interest

elasticity of consumption for short-run is around 0.5 but the magnitude is

sensitive to choices of parameters included. He argues that adding more

uncertainties to the basic model might increase or decrease the value of the

interest elasticity of consumption, perhaps significantly. However, those

uncertainties can not transform positive elasticity into negative

ones(Elmendorf and System 1996)Elmendorf and System 1996.

Pourgerami and Ghouri state that the effect of interest rate on consumption

has an important implication in terms of capital formation and income growth

required in an economy. The study of effect of influences of interest rate on

consumption carried out in Pakistanhas shown that changes in interest rate

do not influence consumption in short run.The author suspects that the

consumption function which is insensitive to interest rate to be an indication of

unwillingness or inability to alter the existing consumption pattern by taking

advantage of higher rates of return on interest bearing assets (Pourgerami

and Ghouri 1991)Pourgerami and Ghouri 1991.

The effect of fluctuation in interest rate in the saving or consumption can be

represented by a variable. This variable can be either in the form of saving or

in the form of consumption. The variable in the form of saving is called

interest elasticity of saving. This represents the change in saving by one

percent change in interest. The variable in the form of consumption is called


72

interest elasticity of consumption. This interest elasticity of consumption is

reciprocal of interest elasticity of saving. There have been a large number in

of empirical studies in this topic. However, most of the results do not coincide

at a single point. Moreover, in developing countries the result is more

contradictory. A two-period model is a commonly used model to analyse the

effect of interest rate on consumption by the use of interest elasticity of saving

or interest elasticity of consumption. But Balassa did not find a common point

in the study of the effect of interest rate on consumption with the use of two-

period model either. In the two-period model, both the substitution effect and

income effect act simultaneously which makes it difficult to know the net

effect. The price of the future consumption is decreased when there is rise in

interest rate due to the substitution effect. Now,the substitution effect will

come in play and people will save more today to support consumption in the

future, unless the expenditure, which is going to be in future, is on inferior

goods. But at the same time, the income effect comes into paly which

motivates individuals to consume more today as well as in the future time.

This results less saving. So the net result is dependent on the strength of

income and substitution effect. This situation makes the result contradicted

and hard to know in priori (Balassa 1989)Balassa 1989.

There have been a number of empirical studies to estimate the relationship

between interest rate and consumption in both the developed and developing

countries. But, it is true, all the results obtained from different researches do

not agree on a single outcome (Balassa 1989)Balassa 1989 and (Gylfason

1981)Gylfason 1981. This could be because most of the studies did not

consider the effect of inflation. However, “bulk of the empirical evidences

accumulated since 1967 supports the view that consumption and interest rate

are inversely related” (Gylfason 1981)Gylfason 1981. When Gylfason studies

the quarterly time series data of United States with one percent statistical
73

significance, he found interest elasticity of consumption to be -0.3. This

indicates that the Gylfason’s finding on the relationship of interest rate and

consumption are negatively related (Gylfason 1981)Gylfason 1981.

One of the important authors who found the effect of interest rate on

consumption to be positive is L. Taylor. Through the review of different

empirical studies Taylor suggested that the matter of relationship between

interest rate and consumption is contradictory. This may be because they are

derived for a particular context and are based only on aggregate time series

data. He studied different types of marginal propensity associated with

various types of income and he mainly focused on the distinction between

labour income and property income. He has assumed that personal saving is

linearly related to the income and existing stock of financial income. Finally he

suggested that in short run any changes in interest rate is positively related to

the consumption. Moreover, the property income is higher than the labour

income so the propensity to consume associated with property income is

higher compared to labour income (Taylor, Duesenberry et al. 1971)Taylor,

Duesenberry et al. 1971.

There are number of empirical evidences that support the negative

relationship between interest rate and consumption. This means, on the other

hand, those empirical evidences support the positive relationship between

interest rate and the saving.One of them who supported the positive

relationship between interest rate and saving is Summers. He does not agree

with most of the theoretical finding about the interest elasticity of saving which

show it likely to be quite small. Summers derivation of aggregate saving

function is based on the continuous time life-cycle framework in his 1981

paper. In the examination of interest elasticity of saving, he did not agree with

the traditional two-period model, rather he assumed that all the income is

received in first period. In his framework he assumed that the conflict between
74

present and future consumption which, is elasticity of substitution, is

determined by the interest elasticity of saving. Saving is determined by

interest elasticity. The cut off point in the elasticity of substitution is one. When

the interest elasticity is greater than one, interest rate and saving are

positively related, saving increases with the increase in interest rate, but not

necessarily at the same rate and when the interest elasticity is less than unity,

interest rate and saving are negatively related, saving decreases with the

increase in the interest rate, but not necessarily at the same rate. Summers

suggested that the two important aspects of reality have been obscured in the

two -period model of interest elasticity of saving. One is that the result of net

positive saving is because the young who save are more numerous and

affluent compared to retired dis-savers. Otherwise all the savings are

eventually consumed and there will be no bequests. The other is the concept

of time value of money and states that with the increase in interest rate the

present value of life time income decreases. Since all the incomes are

received in the first period, as interest rate increases the endowment declines

because of discounting. This fall in income reduces the consumption,which

eventually affects the saving. Summers found interest elasticity of saving to

be in between 0.4 to 0.9. Summers has related his findings with

Boskin’s(1978)1978 finding of elasticity of saving. Finally, Summers

considered the importance of bequests. He suggested that bequests may

represent a large fraction in the formation of national capital.He suggested

life-cycle hypothesis did not consider the importance of desire to leave

bequests on the assumption of no bequests.Summers claimed that when the

desires to leave bequests were accounted, the elasticity of saving is

increased to the range of predicted value. Evans (1983)1983,on his

simulation analysis of theoretical models, criticized the conclusions made by

the Summers. When Evans considered the assumption of positive rate of time
75

preference, he obtained interest elasticity of saving to be near the value

obtained by Summers(1984)1984. The elasticity values were declined when

zero or negative time preference was assumed. However,

Summers(1981)1981 noted that “the negative rate of time preference does

not appear realistic and the interest elasticity of saving is generally above

0.3”. On the analysis of Evans simulation of theoretical models he used

Summers’s (1981) assumptions of productivity growth rate of 2 percent per

annum, 4 percent after tax real rate of return per annum, 1.5 percent

population growth per annum, fifty years of economic lifetime and forty years

of earning span. When the lower rates of population growth and return were

assumed the interest elasticity of saving declined. Evans used different values

of risk aversion coefficient and calculated different variables. He found when

the risk aversion coefficient is higher the lower is the income wealth ratio,

interest elasticity and the saving rate.

He also noted that when the time preference rate is larger, higher is the

interest elasticity of saving and lower the wealth income ratio and saving rate.

This means saving in youth is less than consumption, which is empirically

realistic too. In youth, the interest elasticity of saving and negative and works

in opposite direction compared to earning age. In the young age higher

interest rate implies higher interest outlays rather than higher interest receipts.

Evans also considered the interest elasticity of saving in transition to be

equally important. He suggested change in interest rate is unanticipated

“surprise” in transition. So, all the estimates made before the transition should

be re-estimated after the occurrence of change in interest rate. Moreover,

individuals assume it to persist forever. Another important factor that Evans

considered in his simulation analysis was the bequests. He claimed that the

inclusion of bequests will reduce the elasticity of saving. However, Summers

objected to this statement and noted that “as long as any part of population is
76

saving for altruistic bequests, the long-run partial equilibrium elasticity of

saving with respect to the rate of return will be infinite” (Summers, 1984, pp.

250-51)

According to Boskin “the effect of interest rates on economic behaviour,

particularly on saving and consumption, has been a central concern of

economists at least since the development of classical

macroeconomics”(Boskin 1978)Boskin 1978. He considers the relationship

between interest rate and consumption or saving to be of vital importance in

economic policy making. He employed 1929 to 1969 U.S. data to find the

relationship between private saving and rate of return. He has found interest

elasticity to be 0.4. This result tells us that interest rate and saving are

positively related. Thus, interest rate and consumption are negatively related

(Boskin 1978)Boskin 1978. Wright (1967)1967 has produced a similar result

of negative relationship between interest rate and consumption. His attempt to

derive the consumption function is quite similar to that of Friedman’s

“Permanent Income hypothesis” and Modigliani’s “Life Cycle Hypothesis”. He

used 1897 to 1959 USA data to compute the interest elasticity of saving. He

found it to be positive with the value of 0.5. This means interest rate and

consumption are negatively related. Blinder (1975)1975 has found a similar

result. However, the author has considered the result to be very small. The

researcher has mainly focused on the effect of distribution on consumption.

He found that consumption is independent of income distribution. While

estimating the aggregate consumption the author has considered bequest to

an important factor and life time available resources to be a prime factor

rather than current income. The available life time resource is dependent on

the age, length of life, the rate of interest and the consumer taste.

Similarly, Blinder and Deaton (1985)1985 found interest elasticity of

consumption to be negative. This negative value was found to be -2.3. This


77

negative interest elasticity of consumption indicates that the interest elasticity

of saving is substantially high. This negative interest elasticity was found in

the consumption of nondurable goods and services when the nominal interest

rate was considered. However, the author further clarify that “thestrong

elasticity is to the nominal interest rate and does not appear if onlythe real

rate is allowed in the regression” (Blinder and Deaton 1985, p. 489). The

author suggests that the high value of interest elasticity does not remain same

when the “surprise” version of equation is considered. After the consideration

of surprise version of equation the interest elasticity substantially decreases to

-0.8. The surprise version of equation includes unanticipated income and

wealth.

A recent paper which studies the determinants of household saving in

Chinese data has revealed a positive result on the relationship between

interest rate and consumption. However, the study has found a mixed result

on the matter of significances. The research was carried out by Horioka and

Wan (2007)2007 in 2007 using the Chinese data from the year1995 to2004.

The authors have considered several independent variables in his study. One

of them is the real interest to determine household saving. They have studied

the determinants of household saving in urban and rural area. The authors

have found a positive, however, insignificant relationship trend between real

interest rate and household saving in urban areas. But it has revealed a

positive and significant relationship between real interest rate and saving in

rural households. Finally the authors claim that the “real interest rate has a

significant positive impact on the household saving rate for ever sample

except for the sample of urban households, which suggests that the interest

elasticity of saving is positive and is consistent with the permanent income

hypothesis” (Horilka and Wan, 2007, p. 2090).


78

An article by Attanasio and Weber with the title of “consumption growth, the

interest rate and aggregation” has tried to study the elasticity of substitution.

The data have been extracted from the National Accounts and the Family

Expenditure Survey. The estimation is based on the time series data taken

over 17 years period 1970 – 1986 in Britain. The result obtained on the

estimation of elasticity of intertemporal substitution on aggregate and average

cohort data have found to be substantially different. The authors have

suggested that the errors on consumption function might be because of

omission of demographic factors such as family composition, education,

employment status etc. The authors have also doubted about the accuracy of

National Accounts data. The reasons for the consideration of building society

deposits interest as an asset returns for the analysis have declared as

commonly held asset, net of tax for standard taxpayers as an asset return and

negative asset holding is common as mortgage during the sample period.

From the analysis of cohort data they revealed that the elasticity of

intertemporal substitution to be almost 0.8. This result is substantially higher

than the result they found on aggregate data (Attanasio and Weber

1993)Attanasio and Weber 1993.

2.6.5 Consumption: Durable vs non-durable

Despite of large number of studies on the topic of consumption there have

been very studies which studied the relationship between interest rate and

consumption of durables and non-durables. Most of the studies have agreed

the importance of interest rate on consumption. However, all the studies do

not agree upon a single result. Moreover, the effect of interest rate on

durables and nondurable may not be in the same direction.

Mankiw(Mankiw 1985)Mankiw 1985 has tried to reveal some of the patterns

of consumption on durables and nondurables in his paper. His paper has

examined the relationship between interest rate and consumption. He has


79

divided consumption in two groups; durable goods consumption and

nondurable goods and service consumption. The presented model has used

post war U.S. data form 1950 to 1981. The used data has been extracted

from fourth quarter of each year. The author claims that the result obtained

from his model is within the range of estimates obtained from previous

studies. To ensure the estimated result gained from the used parameters, the

author has employed different equations with the structural parameters and

has obtained close results. The model has found that the change in real

interest rate highly affects the consumption of durables and nondurable goods

and services. He has suggested that the consumption of durable goods is

negatively related to the real interest rate, whereas, consumption of

nondurable goods and services is positively related to the real interest rate.

The author finds it to be consistent with the casual observations. To

corroborate the model findings, the author has utilized the U.S. data from1979

to 1982 to extract some facts. During the time, the inflation had decelerated to

5.9 percent from 9 percent. By the time three months Treasury bill rose to

10.7 percent from 10 percent. He further noted that during the time,

consumption of nondurables and services rose by 4.9 percent while,

consumption on durables fell by 5.8 percent(Mankiw 1985)Mankiw 1985.

Similarly, Hamburger (1967)1967 tried to examine the relationship between

consumer durable goods and monetary variables. He considered interest rate

as a most appropriate measure of monetary variables. Besides the interest

rate he also considered the aggregate money supply, consumer stock of

liquid assets, the monetary base and the rate of change in money supply as

monetary variable. The author has considered durable goods to be

automobiles and others. Where automobiles included automobiles and parts

and the others included furniture and household equipment. The data has

been taken on the quarterly basis from 1953 to 1964. The author has used
80

Aaalong term corporate bonds yield as interest rate. He found that the effect

of interest rate on the consumption of other durable goods (furniture and

household equipment) is more important than on the consumption of

automobiles and parts (Hamburger 1967)Hamburger 1967.

Most of the findings about the effect of interest rate on consumption of

durables have shown a similar result that the consumption of consumer

durables is highly effected by the change in interest rate (Mankiw, 1985),

(Hamburger 1967)Hamburger 1967, (Heim 2009)Heim 2009. The model used

by Heim (2009) to determine the consumer goods and services has been able

to explain 81% of the variance in service demand, 86% of demand for

nondurable consumer goods and 94% of variance in demand for consumer

durables. Heim used 1960 to 2000 U.S. data to examine the trend in demand

for consumer goods. He divided consumer goods in three categories durable,

nondurable and service. Heim indicated that 92% of total consumer demand

is explained by five drivers, which are interest rates, the exchange rate, credit

constraints, consumer wealth and disposable income. Among them interest

rate plays a least significant role to drive the consumption. He found that the

interest rate plays no role in the consumption of nondurables and services like

entertainment, perhaps the most flexible part of household budget. But the

consumption of durable is dependent on the interest rate. However, the effect

exerted by the interest rate on the consumption of durable is less significant.

The author suspects that the reason for being less significant may be

because the purchases of durables are pre-planned (Heim 2009)Heim 2009.

William Poole (1972)1972 thinks that most of the studies carried out for the

analysis of effect of changes interest rate on consumption is concerned with

two issues; the importance of substitution effect and the consumption of

durable and non-durable goods. The substitution effect determines the pattern
81

of allocation of available resources over time and for the present condition,

the substitution effect determines the consumption of durable versus non-

durable goods. But the author suggests other types of effects, the effect of

inflation and the treatment of gross interest income of households should not

be neglected. Poole considered inflation as a wedge between nominal interest

rate and real interest rate. Further he noted that “following a common practice

in econometric work on consumption, the services of durables are included in

consumption and purchases of consumer durables are excluded but services

of durables must also be added to disposable income. Since, the value of

such services can not be ascertained from market transaction, it must be

imputed” (Poole, 1972, p. 212). The author has considered the durable goods

as an interest generator. The gross yield from the stock of durables is

calculated by multiplication of net rate of return to depreciation rate and to

estimated value of stock of consumer durables. In case of gross interest

income of households, during the time of inflation or deflation, real values of

depreciation of durables are important. This real value of depreciation can be

calculated when the real value of fixed income assets are considered. While

doing, inflation premium precisely compensates the nominal interest rates.

Similarly, this calculation works for the deflation premium so, the issues are

important in both inflationary or deflationary anticipations (Poole 1972)Poole

1972.
82

It is widely accepted truth that the individuals are risk averse and risk is

associated with uncertainty. Individuals want to be certain and safe in every

aspect of their life. Fluctuations and uncertainty in interest rate is also an

important factor of risk. Sandmo(1970)1970 have tried to reveal some of the

facts regarding the future uncertainty and the present consumption. He has

considered two types of uncertainties to causing the risk; income risk and

capital risk. The author has made some distinction between income risk and

capital risk. He noted that “under income risk, increased saving raises the

expected value of future consumption, while leaving higher moments

unexpected” (Sandmo, 1970, p.354). Hence, with the increased future risk

individuals raise the level of saving to compensate the future uncertainty.

However, under the capital risk it is not the same case. In case of capital, both

the mean and variance of future consumption increases with the increase in

saving, which results the conflicting decision between substitution and income

effect. Hence, in case of labour income it is possible to know the resulting

effect between income and substitution effect but the result can not be known

in priori in case of capital income (Sandmo 1970)Sandmo 1970.

Saving is an important activity of every individual’s economic life.

Furthermore, it plays a vital role in accumulation of capital required for a

nation. Feldstein and Tsiang have tried to reveal some facts about the interest

rate, taxation and the saving incentives. The authors have noticed two main

advantage of tax policy over interest rate policy on saving incentives. When

the interest rate is changed it affects every individual buttax may not do the

same. For instance, taxes can be imposed to a particular group in the

population. This caused change in net yield to some groups but not for others.

Furthermore, under the condition of uncertainty, tax changes can be more


83

efficient to interest rate change. The authors suggest that the effect of interest

rate on individuals is different depending upon the category in which the

individuals fall. The categories can be defined as lender, borrower and

neither. The authors have found a positive relationship between interest rate

and saving. This means, there exists a negative relationship between interest

rate and consumption. According to the authors the effect of change interest

rate on saving is high and positive if the individual is neither saver nor

borrower before the change in interest rate. Asimilar relation exists with some

moderate value when the individual is net borrower before the change in

interest rate. If the individual is saver then the effect will be reduced with the

positive sign on saving(Feldstein and Tsiang 1968)Feldstein and Tsiang

1968.

The study of change in interest rate and its effect on consumption or saving

has always been a matter of controversy. We can find varieties of results

regarding this topic. Among them some of the researchers have found

consumption or saving to be quite sensitive to the considered parameters in

the model of analysis. Zietz(1984)1984 has found a similar result that the

consumption and saving is sensitive to considered interest rate

parameters.The author has used the quarterly time series data for all the

variables from the data bank of the Federal Reserve Board. The considered

variables are consumption, disposable income and beginning-period wealth.

The variables have been seasonally adjusted and reported on an annual

basis. The data samples used are from the year 1953 to 1980 of the US

economy. The author faces the problem of inconsistency of parameters

considered. For instance, there are numbers of interest rate in the market

and, unfortunately, none of them represent all of them. This situation makes it

very difficult to estimate a precise value of interest elasticity of saving


84

representing all the individuals. When the author used Aaa corporate bond

rate as nominal interest rate, he found interest elasticity of saving to be 0.224,

while on the other hand using three years government securities as the rate of

return the interest elasticity of saving was found to be 0.01 on the analysis of

sample period data. However, if the data is taken from some particular year,

the result obtained is as high as 0.356 corresponding to sample period result

0.224 and as low as 0.093 corresponding to sample period result 0.01. The

obtained result of 0.356 is quite near to that of Boskin(1978)1978. With the

results obtained from his estimates the author suggests that the selection of

interest rate and the point of evaluation significantly alter the findings of

interest elasticity of saving. This suggests that the interest elasticity of saving

is quite sensitive to selection of parameters and point of time. This conclusion

made by Zietz(1984)1984contradicts with Carlino’s(1982)1982 finding that the

interest elasticity of saving is insensitive to choice of nominal interest rate.

Carlino’s finding also contradicts with Zietz’s (1984) finding in the matter of

sing. Carlino(1982)1982 has found interest elasticity of saving to be negative.

Despite of ambiguity on the matter of the effect of interest rate on

consumption and saving, most of the researchers agree that interest rate is

an important variable for policy makers. It is believed that with the increase in

interest rate, substitution effect comes into play, which substitutes future

consumption for current consumption. Since, increase in interest rate reduces

the present discounted value of total life time income from the resources.

Meanwhile, increase in interest rate also increases household income

encouraging more consumption today (Deaton 1992)Deaton 1992. In the

study of interest rate and consumption relationship it is very difficult, if not

impossible, to know the net resulting effect between income effect and

substitution effect in priori (Balassa 1989)Balassa 1989. However,


85

theoretically, estimation of substitution effect is possible (Fetzer 1998)Fetzer

1998.

Fetzer has tried to reveal some of the facts about the relationship between

interest rate and intertemporal substitution. The author believes that saving

and borrowing smooth the consumption at the time when interest rate

encourages substitution effect. The rise in interest rate postpones current

consumption for future, resulting increase in future consumption, by

increasing saving or decreasing borrowing. And opposite occurs when the

interest rate falls. The author argues that most of the papers have used

market interest rate as their modelling interest rate for all households, though

it is not realistic to assume all house holds can lend or borrow at his interest

rate. Another important fact that author has considered is lending and

borrowing among family members, business associates or friends where

market interest rates may not play any role. In such situations the motivating

factor for lending and borrowing could be some expectations of special

treatment or provision of goods and services in future. So assumption of

monotonic interest rate structure on intertemporal substitution may produce

biasness in the analysis and ignore other effects of interest rate on

intertemporal substitution. To overcome such problem the author has used

household saving and borrowing interest rate from a survey of village in

Indian households instead of using an aggregate data. The author found that

intertemporal substitution is affected by interest rates and the effect is not

always monotonic. Actual borrowing costs are not same for all individuals.

Some pay higher cost of borrowing as compared to others even though the

observed interest rate is same. The author further noted that “consumption

growth is lower for low interest rates (between zero and 12 percent) and

higher for high interest (over 24 percent)” (Fetzer 1998, p.17). However, the
86

author found consumption growth to be higher at zero percent interest rate as

compared to the lower range interest rates (between zero percent and 12

percent).

The reviews of all these literatures have given a platform to do this

dissertation. The reviews have given an experience of dependency of

different variables in different situation and time frame. The review of the

literatures has shown that the parameter of consideration and assumptions in

the research significantly influences the conclusion.

Where is the IS – LM framework???

Where is the AD – AS framework?

Where is the money market?

Where are all the theories of the macroeconomic textbooks we discussed?

I don't see any of these and no graphs.

CHAPTER THREE

30 METHODOLOGY

3.1 Introduction

Consumer expenditure accounts in between 50% to 70% of GDP in most of

the economies and this accounts around 65% in UK. So, the private

consumption is regarded as an important factor for policy making. There have

been numerous studies about the effect of interest rate on private

consumption. However, the result of most of the studies does not coincide on
87

a single point result. “Theoretically, the interest rate has an ambiguous effect

on the current level of consumption. An increase in the interest rate will

encourage a household to substitute future consumption for current

consumption and reduce the present discounted value of total life-time

resources, both cutting current consumption. But it also increases household

income encouraging more consumption” (Fetzer, 1998, p.1). This paper will

try to reveal some of the facts about the effect of interest rate on household

consumption.

3.2 Choice of subject

There are hardly any economic papers which do not talk about the interest

rates. Perhaps, interest rates are the most closely watched element in the

financial market. It drives the decision, whether to lend or borrow, save or

invest or choose the available alternative investment opportunities. Interest

rates are the primary tool to consider while making investments. “Interest

rates are the most pervasive elements in the financial world. They affect

every nook and cranny of financial markets.” (Ritter, Silber et al. 1991)Ritter,

Silber et al. 1991. Interest rate is not only important for the investors but also

for the individuals and the policy makers. Policy makers utilize the interest

rate to stabilize the economy through the interest rate targeting. Further more

it is used to stabilize the economy through controlling the inflation, which in

turn controlled by interest rate operation. Investment in some projects or

saving in some banks, buying is bonds or holding the money is also

determined by the rate of interest (other risk factors being equal). For the

households too interest rate plays a crucial role in determining whether to

spend or to save for the future consumption. Being such an important element

in the financial and economic world was the prime factor for the selection of

this topic.
88

3.3 Research Approach

Research approach defines the way how the research will be started and

concluded. If the research is started from general theory to specific conclusion

then it is called deductive approach and it is often, informally, called “top-

down” approach. Research theories are called inductive approach and it is

often, informally, called “bottom up” approach. This dissertation has adopted

generalized theories with some modification to test the relationship between

the interest rate and the consumption. So, this research is based on an

inductive approach. It has adopted generalized theory of consumption with

some modifications and with the help of observed set of data this dissertation

will try to find a specific relationship between interest rate and consumption.

3.4 Method of Research

There have been numerous researches on the relationship between interest

rate and consumption. However, the conclusions of different research do not

give a precise value. Moreover, many researches do not agree on sign. Some

researches have found a positive relationship between interest rate and

consumption

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100

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PC9yZWNvcmQ+PC9D aXRlPjwvRW5kTm90ZT5= (Weber 1970; Weber

1971; Springer 1975; Elmendorf and System 1996; Horioka and Wan 2007;

Kapoor and Ravi 2009)Weber 1970Weber 1971Springer 1975Elmendorf and

System 1996Horioka and Wan 2007Kapoor and Ravi 2009. Similarly we can

find the researches which have found negative relationship between interest

rate and consumption

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103

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9DaXRlPjwvRW5kTm90 ZT4A (Wright 1967; Feldstein and Tsiang 1968;


125

Mishkin 1976; Boskin 1978; Gylfason 1981; Summers 1981; Carlino 1982;

Summers 1984; Deaton 1992; Fetzer 1998)Wright 1967Feldstein and Tsiang

1968Mishkin 1976Boskin 1978Gylfason 1981Summers 1981Carlino

1982Summers 1984Deaton 1992Fetzer 1998. Meanwhile, we can see some

of the researchers who suggest that there is no significant relationship

between interest rate and consumption

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mQ+PC9DaXRlPjwvRW5k Tm90ZT4A (Keynes 1936; Poole 1972; Balassa

1989; Pourgerami and Ghouri 1991; Attanasio and Weber 1993; Fernandez-

Corugedo 2004; Keynes 2006; Heim 2009)Keynes 1936Poole 1972Balassa

1989Pourgerami and Ghouri 1991Attanasio and Weber 1993Fernandez-

Corugedo 2004Keynes 2006Heim 2009. This dissertation has tried to put a

brick on it. This dissertation has tried to explore the relationship between

interest rate and consumption, whether they are interest rate is positively

related, negatively related or the interest rate has no significant impact on

consumption. The exploratory researches act as a foundation for the further

explanatory researches.

3.5 Research Strategy

There are different research strategies to conduct a research. However, “we

must emphasise that no research strategy is inherently superior or inferior to

any other” (Saunders et al., 2009, p.141). The selection of research strategy
140

depends on the questions that the paper is trying to answer and the available

resources. Moreover, a research can include more that one

researchstrategies so should not be thought of as being mutually exclusive.

Most of the economic researchers employ the case study strategy. The case

study strategy studies a phenomenon over a particular territory, subject area,

organization, behaviour etcetera. However, it is not the only one strategy they

use, for instance

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HM+PC9yZWNvcmQ+ PC9DaXRlPjwvRW5kTm90ZT5= (Springer 1975;

Balassa 1989; Pourgerami and Ghouri 1991; Fetzer 1998; Horioka and Wan

2007; Kapoor and Ravi 2009)Springer 1975Balassa 1989Pourgerami and

Ghouri 1991Fetzer 1998Horioka and Wan 2007Kapoor and Ravi 2009 have

used the case study strategy with survey strategy. This dissertation has tried

to use case study research strategy. This dissertation has taken the
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consumption of the United Kingdom as a case. The average consumption

data of the United Kingdom has been observed over the period of 20 years

from 1985 to 2005, for long-run, to reach the conclusion. For short-run the

quarterly data has been employed over the 5 years period from 2000 to 2005.

3.6 Research tool

Research tools are those which are used for the analysis of observation. The

natures of the tools are different for types of analysis. Those analysis tools

which are used for qualitative analysis may not be appropriate for the

quantitative analysis and similarly those tools which are used for quantitative

analysis may not appropriate for the qualitative analysis. In case of business

management the commonly used qualitative analysis tools are the

AnsoffMetrix, BCG (Boston Consulting Group) Metrix, Porter’s Five Forces,

SWOT (Strength, Weakness, Opportunity and Threat) analysis etcetera. On

the other hand, the tools used for the quantitative analysis are more technical.

It could be econometrical, mathematical or statistical. This dissertation has

employed empirical econometrical tools for the analysis of the observed data.

3.7 Choices of data collection

Collection of data is one of the most important tasks in the research. It can be

achieved through different methods of data collection. It can be mono method

and multiple methods. Mono method of data collection employs single data

collection technique; however it could be primary or secondary and qualitative

or quantitative. Multiple methods of data collection use combination of data

collection techniques. In the recent years mixed method of data collection has

developed and been able to gain the popularity. However, the choice of data

collection is determined not only by the quality of data collection method but

also by some other factors which have equal importance such as available
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time, and other resources. The collection of data is entirely secondary data

and the used analysis procedure is the quantitative.

3.8 Time Horizons

Time horizon is related to the collection of data. Time horizon defines whether

the data of a phenomenon that needs to be collected are from a particular

time or from a period of time frame. When the data are collected from a

particular time then it is called cross-sectional studies and when the

phenomenon is studies over a period of time frame it is called longitudinal

studies. “The main strength of longitudinal research is the capacity that it has

to study change and development” (Saunders et al., 2009, p.155). This

dissertation has tried to study the effect of interest rate on consumption and

GDP in United Kingdom over a period of 20 years from the year 1985 to 2005

for the long-run and over the period of 5 years from the year 2000 to 2005.

3.9 Sources of Data

There are different ways of collecting data. The technique used for data

collection is determined by the sources of data. The method of data collection,

sources of data and access to data play a vital role in research design. The

conclusion of this dissertation is based on the analysis of secondary data.

These data are mainly collected from the official website of Bank of England

(Central Bank of United Kingdom), official website of International Monetary

Fund (IMF) and the UK National Statistics. However, the require data may

also be collected from the journal articles, news papers and other trusted and

reliable websites. Since all three primary sources of information are public

institutions, all the data required to conduct this dissertation are freely

available. To reach the conclusion through the regression analysis this

dissertation requires the data of interest rate, household consumption, total


152

consumption, household disposable income, wages, inflation, import, export

and government investment data. All the required data regarding the interest

rate has been extracted from the official website of Bank of England and

remaining all the data have been collected from the official website of UK

National Statistics.

3.10 Key Variables

A variable is an alphabetic or an alphanumeric symbol in a model whose

value keeps varying during the execution of the model. However, variation in

one variable can be the result of variation in another variable. In such case,

former is called dependent variable and latter is called independent variable.

3.10.1 Dependent Variable

The dependent variables hold the primary interest of the research. In this

research household consumption and GDP of the United Kingdom have been

taken as dependent variable to understand the relationship of interest rate

with household consumption and GDP. Similarly, disposable income and

investment have been considered as dependent variable to understand the

relationship of interest rate with household disposable income and

investment.

3.10.2 Independent variable

The variation in independent variables fluctuate the dependent variable.

However, the relationship between the dependent variable and independent

variable could be only the numerical correlation or could be cause and effect

relationship. In this research, for the model of consumption, household

disposable income, official bank rate and previous year’s consumption have

been taken as independent variables. Similarly, for the model of GDP,

consumption, investment, government expenditure, export, import and


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interest rate have been considered as independent variables. And for the

other two models interest rate has been considered as an independent

variable.

3.11 Model Development

In most of the countries consumption occupies the largest chunk of GDP and

in the UK it occupies around 65% of GDP. There have numerous research

regarding the consumption among them some of the researchers have tried to

find the relationship between interest rate and consumption. However,

researchers’ findings do not agree on a unique result. Some researchers have

suggested positive relationship, while others have suggested negative

relationship. Meanwhile, some found insignificant relationship between

interest rate and consumption, while others commented that it was not

possible to find the relation in priori. The main reason of divergence of

findings could be the result of the assumptions regarding the models, other

economic situations, study time frame and the region of study.

In this dissertation a consumption function has been defined whose two main

determinants are income and interest rate (as most previous studies have

done), and the real exchange rate has been added to the model as another

determinant. Thus, the long-run consumption function in this study takes the

following form:

lnCt=α+βlnyt+ylnrt+φlnREt+εt (3.1)

Where C is real consumption; y is real income; r is the nominal interest rate;

and RE is the real effective exchange rate. The expectation is that the

estimated coefficient β should be positive and y negative. Since RE is the real

effective exchange rate, a decline in RE reflects a real depreciation. Based on

our theoretical argument, real depreciation lowers aggregate consumption;

therefore, it is expected that the estimate of φ will be positive.


154

To estimate the long-run relationship between the dependent variable and the

independent variables, equation (3.2) has been defined as a simple model in

log-linear form. Here, Wt is the nominal wage, Ptis the average price level, Ut

is the unemployment rate, and At is labour productivity per hour. The

estimated coefficient of β is expected to be positive, y negative and φ positive.

lnWt=α+βlnPt+γlnUt+φlnAt+εt (3.2)

Another main purpose of this dissertation is to investigate the impact of

currency depreciation on domestic investment by including the exchange rate

in the investment function. Following the main argument of this dissertation,

the real investment is a function of the real income, nominal interest rate and

real exchange rate. The long run investment function, therefore, takes the

following form:

lnIt=α+βlnyt+γlnrt+φlnREt+εt (3.3)

Where I is real investment; Y is real income, r is the nominal interest rate; and

RE is the real exchange rate.

The main assumption of this theory is the long adjustment lag of wages

behind inflation. Therefore, it is important to distinguish the short-run effects

from the long-run effects. This dissertation introduces the short-run dynamics

into equation (3.1).

The long-run effects would be meaningful if the lagged-level variables as a

proxy for the lagged error term from (3.1) are jointly significant (i.e.

cointegrated). Meanwhile, in order to test this cointegration hypothesis,

Pesaran et al (2001) propose applying a non-standard F-test with new critical

values that take into consideration the integration order of all variables. This

has been rewritten in equation (3.4)

∆LnWt = a+i=1n1bi∆LnWt-i+ i=0n2ci∆LnPt-i+i=0n3di∆LnUt-

0+i=0n4ei∆LnAt=i+δ0 LnWt-1 +δ1LnPt-1 +δ2LnUt-1 +δ3LnREt-1 +Vt (3.4)


155

The upper-bound critical values are tabulated by assuming that all variables

are of first order integration, and the lower-bound critical values are tabulated

by assuming that all variables are of zero-order integration.

3.12 Hypothesis

The null hypothesis is that there is no long-run relationship between the

variables. To determine the long run relationship between the variables, the

calculated F must be greater than the upper bound critical values. If the

calculated F is less than its lower-bound critical value, on the other hand, we

do not reject the null hypothesis. Meanwhile, if the calculated F lies between

the upper-bound critical value and the lower-bound critical value, the result is

inconclusive and we need to run the appropriate unit-root tests.

3.13 Value of study

This dissertation relies on a simple aggregate consumption and investment

functions in which the real exchange rate as another determinant of

consumption and investment in addition to real income and interest rate, is

included in the models. The value of the study is dependent on various factors

that cause error in the study. Error might occur during model development,

data collection, data analysis and interpretation. Everything possible attempt

has been done to minimise the possible errors.

3.13.1 Reliability

Reliability of the research is based on the reliability of measurement. It is also

defined as the repeatability of the measurement or in the other way it is the

consistency of the measurement. In order to attain reliability different

precautions can be taken, however in case of secondary quantitative data

analysis reliability of data source is most important. In order to achieve

reliability in this dissertation only one source of data has been used. Since
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this source is data the Bank of England and UK National Statistics they are

considered to be highly reliable data source.

3.13.2 Validity

Validity is the strength of conclusion that can be matched with the available

evidences. According to Cook and Campbell (1979)1979 the validity is

defined as “the best available approximation to the truth or falsity of a given

inference, proposition or conclusion”. Validity in case of secondary

quantitative research is highly dependent on the validity of the data source.

The Bank of England and the UK National Statistics are regarded as a valid

source of data.

3.14 Result Expectation

Research is a deliberate search of particular knowledge in systematic and

scientific way, where literature review is regarded as a foundation. The review

of literature lets the researcher know what had already searched and what

has been found. Besides this, the review of the literature makes the

researcher think about relationship between research finding and

circumstances under which the research was carried out (Boskin 1978;

Balassa 1989)Boskin 1978Balassa 1989. On the basis of analysis of

literature of different authors, preliminary study of GDP, consumption and

interest rate, this research expects the negative relationship of interest rate

with both the consumption and the GDP in the United Kingdom.
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CHAPTER FOUR

40 DATA ANALYSIS

4.1 Introduction

Development of an individual economy passes through different economic

phases. Sometimes it is booming and sometimes it suffers from recession.

This phenomenon can be viewed as projection of consumption and

investment strategies of the individuals and the government of the country.

Interest rate, being a major factor of economics, plays a great role in

economic activities carried out by nation and the nationalities. A change in

interest rates may affect other factors of the economy. For instance,

investment strategies of the investors, consumption strategies of the

individuals, foreign exchange, imports, exports etc. are affected by the

interest rates. An increase in interest rates may decrease the investment,

decrease the consumption, and affect the exchange rates and finally may

influence the GDP of the nation. However, the effect of the interest rate on

consumption behavior has been a subject to controversy. Hall, in his famous

paper in 1981, studies the elasticity of intertemporal substitution, or savings

and consumption sensitivity degree to the real interest rate. In this paper,

instead of estimating the consumption or saving function, he estimates the

representative agents' utility function parameters. He tries to explain the

income and interest rate relationship based on a much broader

macroeconomic idea which is not necessarily stable over time.He argues that

depending on expectations about the real interest rate, consumers change

their consumption. Thus, expectations are playing a key role in his model. Any

change in consumption with regard to change in real interest rate is called the

intertemporal elasticity of substitution. In this paper, Hall concludes that the


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elasticity of intertemporal substitution is usually too small, but is definitely

precise (something around 0. 1 or even zero). The meaning and implication of

the intertemporal substation effect is a very important issue in

Macroeconomics. Whereas, according to Hall, postponing the consumption

from today until tomorrow (day to day) as a result of a change in the interest

rate, leads to four important issues: First, an increase in interest rate will lead

to a decline in consumption and total output even if other elements of

aggregate demand increase. Second, taxing the interest income will create a

deadweight loss. Third, relative to other issues, national debt does not look

very important. Fourth, during the business cycles, consumption moves in the

same direction as changes in the real interest rate.

It is important to mention that over the past three decades, most of the

research on consumer behavior has focused on a utility function instead of

using the consumption function. Several conclusions have been derived from

the estimation of the Euler equations. For example, according to Hansen and

Singleton(1982)1982, and Campbell and Mankiw(1989)1989, data usually

rejects the representative agent's hypothesis model. On the other hand, some

economists have paid attention to the aggregation problem of the Euler

equation and omitted constraints or its inability in approximating the real

consumers' behavior.

Campbell and Mankiw (1989) mainly argued about the effect of stock price

changes on consumption. Their study was a different approach to the

Permanent Income Hypothesis, and was greatly affected by Robert Hall's

outstanding findings in 1978. According to them, there exist two different

types of consumers. The first type of consumers is forward-looking and

usually consumes their permanent income, but at the same time they do not

intertemporalIy substitute their consumption in reaction to interest rate

changes. The second type is those consumers who prefer to consume their
159

current income and do not care about their permanent income. After testing

the consistency of the Permanent Income Hypothesis, Campbell and

Mankiw(1989)1989 concluded that there is not any correlation between

expected changes in consumption and the real interest rate. However, it is

very important to remember that in Hall's original Euler equation approach;

real interest rate was considered constant. Meanwhile, Campbell and

Mankiw(1989)1989 not only paid attention to the random walk effect, but they

also looked seriously at the effect of the real interest rate.

The purpose of this dissertation is to examine the relationship between

interest rate, consumers’ consumption and the GDP of the UK. A nation’s

Gross Domestic Product is a measure of its total economic market output. As

such, it represents the lead indicator of the well-established system of

economic indicators. But its importance has long grown beyond its primary

technical and scholarly functions. It has taken on a much wider role as

modern society’s main gauge of economic and, almost by default, social

progress. The opening citation illustrates the state of affairs rather well. What

the economist in question is implying, perhaps unwittingly, is that the social

consequences of economic policies are of no concern because economic

analysis is believed to be conductible in isolation from other aspects of human

existence. From this reductionist attitude, it is indeed only a very small step

towards equating the, in whichever way measured, economic good with the

wider common good of our society.

A well known commentator of The Independent laments that Europe is poorer

than the United States in GDP per capita terms: ‘The UK is only barely

catching up. The rest is not only poorer but becoming even more poor’

(McRae, 2007). He warns of a mass exodus of Europe’s best talent if this

problem is not fixed soon. His solution is to make Europe grow faster in order

to prevent the ‘gap in wealth’ from widening. The grave social and
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environmental ‘side-effects’ of the American socio-economic model seem to

be of no concern.

In a similar vein, Gordon Brown, as reported in The Guardian (Seager and

Milner 2006)Seager and Milner 2006, once called on Britain ‘to become "an

evangelist for globalisation", arguing free trade, open markets and flexibility

were the preconditions of success in the global economy.’ There is little doubt

as to what is to be achieved by these means: more economic growth, above

anything else. Moreover, by resorting to semi-religious language, he presents

free trade, open markets and flexibility as absolute positives and denies

counter perspectives any legitimacy (e.g. restricted trade to protect social and

environmental standards).

Stunningly, even the UK’s Sustainable Development Report (Department for

Environment; Food & Rural Affairs, 2003) states as the overarching objective

for Britain: ‘Our economy must continue to grow’, without giving reasons or

considering the fact that eternal growth is a natural scientific impossibility in a

closed physical system.

Presumably some people may also die, species may go extinct, coastal areas

and islands may disappear, nations may collapse, and countless people may

see their way of life destroyed, but there does not seem to be a more

convincing and more universally understood way of summarising the

impending tragedy than in the loss of a fifth of global GDP (most of which can

actually only be lost in the rich countries of the North and not where the

physical realities of global warming could be most devastating).

The quintessence of these examples is a simple one. GDP figures and other

economic indicators do provide a powerful frame of reference for how to

perceive the world. Daly and Cobb (Daly, Cobb et al. 1994, P. 63) observe

that this unites ‘economists, politicians, financiers, humanitarians, and the

general public’ and all assume that GDP ‘is closely bound up with human
161

welfare’. Obviously – and this shall not be disputed in this thesis – there are

very good reasons for focusing on the economic aspects of life. However,

there are also other things we can and should consider when we judge the

standing of a nation in the world and its citizens’ quality of life. Our culture

need not and should not be so one-sided. Furthermore, we should constantly

remind ourselves that no part of official statistics is divinely ordained. Socio-

economic indicators measure what they do because they were constructed

that way by expert communities.

In light of all that, this thesis is about the very subject matter that is also at the

heart of economics. The eminent welfare economist AmartyaSen chose the

following words to describe it: ‘The term “social welfare” (…) refers to the

“ethical value” or the “goodness” of the state of affairs of the society’ (Sen,

1991, P.15). Indeed, welfare is one of the most central ideas surrounding

human existence (Rescher 1972)Rescher 1972. The notion is so fundamental

that the English language has produced many linguistic relatives such as well-

being, quality of life, common good and so forth. It deserves scholarly

attention in its own right, but even more so in light of the dominance of the

GDP-cult. If assessing the collective welfare of societies in terms of GDP

indicators has become the default mode, then this research project is about

exposing the subject matter to renew and deeper scholarly attention.

The history of the idea of economic growth is diverse and in parts surprising.

Classical economists were naturally interested in growth, as they saw the

potential for increasing social utility. However, they had not yet produced any

coherent theoretical framework; nor did they have the means and concepts to

quantify the total economy in a meaningful way (Landreth& Colander, 2002).

Starting with the marginalist revolution, economics became technically more

sophisticated, but also staunchly micro-orientated. As a matter of fact,

macroeconomics was not in fashion until Keynes’ general theory was noticed
162

in the 1930s. Eventually, theories of economic growth gained ground after the

national accounts provided hard figures that could be put into models

(Kuznets, 1974). In essence, the operationalist joke about intelligence – that it

simply is the figure that comes out of an intelligence test – is also applicable

here: apparently, economic growth is what GDP measures, increased market

output (plus some imputations) either in total or per capita (Easterlin, 1996, P

31).

Nevertheless, the early growth literature was remarkably contextual and

balanced by today’s standards (e.g. Eltis, 1966). The links between growth

and other topics of concern – such as unemployment, public expenditure,

population growth etc. – were recognised and discussed, but it was not yet

asserted that economic growth would always be the best or only answer to

most economic, social or fiscal problems (there is also policy, distribution and

innovation). Crucially, there was awareness that growth can entail social costs

that are incommensurable with the national accounts. Furthermore, it was

fully acknowledged that ‘economic growth may be a national objective for

non-economic reasons, for national prestige or national strength or national

purpose’ (Tobin, 1966, P. 94). Naturally, the arms-race with the Soviet Union

was quoted as a common motivation for economic growth in the US (Gutman,

1964).

Meanwhile, a transition from theorising to mythologizing seems to have taken

place. Simon Kuznets and other national accounts pioneers used their new

quantitative insights to retro-estimate growth figures from past centuries

(Maddison and Maddison 2004)Maddison and Maddison 2004. At some point

it became the accepted standard to locate the beginning of modern economic

growth around the ‘golden’ liberal age of the early 19th century. Although

increasingly challenged by contemporary economic historians, a powerful

myth has evolved that associates growth with entrepreneurial freedom in


163

general and free trade in particular (Easterlin, 1996; Chang, 2005).

Questioning the desirability of growth or the validity of GDP is for the most

part left to unorthodox schools of thought. Ecological economics, for instance,

has been questioning the wisdom of excluding the resource and carrying

capacity limits of the ecosystem from mainstream growth models (Georgescu-

Roegen and Georgescu 1971)Georgescu-Roegen and Georgescu 1971,

(Costanza, 2005). It cannot be overstated at this point that the mainstream

perspective of welfare economics implies an economy that can never reach a

state of saturation. The economic model of the consumer is constructed in

such a way that there is no diminishing marginal utility of total consumption;

and growth models are constructed in such a way that there is no physical

limit to production (as it depends ultimately only on human ingenuity, but

decidedly not on natural resources). However, this vision of an eternally

growing economy seems to clash with the physical realities of the world we

inhabit (Daly, 2005).

Concluding, the supremacy of unreflective pro-growth attitudes is especially

pronounced, and troublesome, in a number of international organisations,

such as the World Bank, the OECD and the World Economic Forum. The

formation of this pro-growth camp has coincided with an influential neo-

institutionalist perspective in economic theory. It has been urging reforms in

labour markets, education systems and other social arenas to promote growth

(Sykes & OECD, 2004). By implication, the close production-welfare link that

Simon Kuznets (unsuccessfully!) wanted to integrate into the national

accounts is now widely taken for granted. As is his ‘trickle down’ theory

according to which a growing economy is bound to ultimately benefit

everyone in society, even under conditions of distributional inequality

(Kuznets 1955)Kuznets 1955.


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4.2 The Empirical Results

The data for this study was collected from the website of Bank of England,

International Monetary Fund and the UK National Statistics. The information

about the interest rates and exchange rates was accessed from the official

website of Bank of England. The information about the consumption,

investment, government expenditure, imports and exports was obtained from

the official website of UK National Statistics and other required international

data was extracted from the IMF website.

Equation (3.1) is estimated by applying the Ordinary Least Square method

(OLS). Following Bahmani-Oskooee and Tanku (2008), a maximum of four

lags are imposed on each first-differenced term and Akaike's Information

Criterion (AIC) is employed to select an optimum model for each country. The

results for each optimum model are reported in Tables 1.

Table 1: Full Information Results for UK-Consumption


Panel A: Short-run Coefficient Estimates
Variables Lag order
1 1 2 3
ALnY 1.22(6.05) -0.80(3.16) 0.62(2,89) 0.09(0.79)
ALnr -0.03(3.35) -0.02(1.69) 0.06(5.50) -0.03(2.31)
ALnER 0.05(1.43) 0.17(5.03) 0.02(0.78) -0.07(2.68)
Panel B: Long-run Coefficient Estimates
Constant LnY LnER Lnr
-4.13(4.69) 2.92(18.00) -0.70(4.72) 0.20(3.32)
Note: Absolute values of the t-ratios inside the parentheses.

Since the main purpose is to distinguish the short-run effects of currency

depreciation on consumption from its long-run effects, only the short-run

coefficient estimates for the real exchange rate are reported. Tables 1 which

is reporting the short-run results, indicate that the real exchange rate carries

at least one significant coefficient in UK, implying that indeed, currency

depreciation has short-run effects on consumption, supporting

Alexander(1952)1952 argument. Furthermore, the short-run effects last into

the long run only in the country. In U.K., the real exchange rate carries a

coefficient that is significant at the 5% confidence level. This may imply that

either for the country our estimation period is not long enough during which
165

wages adjusts to inflation or there are wage-price rigidities that slow down the

adjustment process. Of course, to make sure our long-run findings are not

subject to the spurious regression problem, cointegration among the variables

must be established. Based on the results which are reported in Tables 1, the

estimated long-run coefficient is significant for the UK. Moreover, the long-run

results show that the real income (Ln Y) has a significant positive coefficient

implying that economic growth increases domestic consumption. As for the

effect of nominal interest rate (Ln r), the results in Table 1 actually show that

the estimated coefficient.

The effect of interest rate on consumption behavior has been studied

extensively in the macroeconomic literature and is controversial.

Wright (Wright 1967)Wright 1967 and Heien(Heien 1972)Heien 1972 found “a

negative relationship between interest rate and consumption” (Heien, 1972, p.

32). On the other hand, Weber (Weber 1970)Weber 1970 and Springer

(Springer 1975) estimated “a positive and significant effect of interest rate on

consumption” (Weber, 1970, p. 43). Lusardi(Lusardi 1990)Lusardi 1990,

Wilcox ( Wilcox 1990) and Elmendorf(Elmendorf and System 1996)Elmendorf

and System 1996 found an insignificant effect of the interest rate on

consumption. Based on these studies the absence of a significant relationship

between interest rates and consumption might be explained due to two

simultaneous effects that interest rates have on consumption. While an

increase in interest rates (an increase in cost of financing) may induce a

reduction in consumption of durable goods and services, it could also raise

future incomes from each dollar saved in the current period and thus increase

current consumption. Consequently, the direction and magnitude of the effect

of interest rate on consumption expenditure remains ambiguous.

Table 2 tabulates the results of the F-test for cointegration along with other

diagnostics statistics. For these long-run results to be meaningful there must


166

be evidence of cointegration either by the F test or by the ECM,.¡ criterion.

Obviously, the calculated F-statistic is greater than its upper-bound critical

value of 3.77 in most of the countries, including all ten countries in which

Alexander's hypothesis was supported (Argentina, Australia, Bangladesh,

Chile, Greece, India, Indonesia, Mexico, Senegal, and Zambia). In order to

determine whether the adjustment of all variables is toward equilibrium, we

use the long-run coefficient estimates and form an error-correction term

(ECM). After replacing the linear combination of the lagged-level variables

with the lagged error correction term, the model is estimated one more time at

optimum lags. A significantly negative coefficient, which also measures the

adjustment speed, will be an indication of adjustment toward long-run

equilibrium.

Table 2: Diagnostic Statistics for Consumption Models


Diagnostics Statistics
F at optimal lags ECMt-1 LM RESET Normality CUSUM CUSUMSQ Adj.
Country
R2
Mexico 13.51 -0.44(7.96) 3.49 7.47 0.38 S US 0.94
Morocco 13.97 -0.99(8.43) 7.03 0.36 0.83 S S 0.94
New Zealand 4.81 -.08(4.45) 0.18 4.21 3.22 S S 0.87
Niger 2.65 -0.58(3.64) 0.20 0.05 1.75 S S 0.91
Nigeria 2.08 -0.19(1.69) 11.37 1.15 6.79 S S 0.10
Norway 5.89 -0.14(5.34) 1.19 5.04 5.01 S S 0.83
Pakistan 5.64 -0.14(5.43) 0.24 -0.16 0.30 S S 0.79
Philippines 3.93 -0.04(4.42) 1.76 16.26 4.32 S S 0.86
Senegal 9.24 -0.19(6.93) 6.26 0.86 12.97 S S 0.89
Singapore 2.64 -0.58(3.63) 0.20 0.05 1.75 S S 0.90
South Africa 4.43 -0.15(4.71) 2.04 0.01 1.29 S S 0.89
Spain 5.76 -2.51(5.63) 0.20 0.05 1.75 S S 0.80
Sri Lanka 6.92 -0.77(5.75) 1.23 0.29 0.28 S S 0.83
Sweden 13.35 -0.23(8.17) 12.56 4.55 3.52 S S 0.90
Thailand 14.29 -0.06(7.71) 0.01 -0.06 1.74 S S 0.67
Tunisia 14.30 -0.15(7.75) 0.04 0.06 1.74 S S 0.67
UK 9.34 -0.06(7.71) 0.03 1.60 1.98 S S 0.99
US 13.71 -0.22(8.35) 3.85 1.37 0.69 S S 0.96
Venezuela 1.53 0.01(2.18) 0.80 4.02 2.94 S S 0.07
Zambia 12.24 -0.38(7.89) 4.41 0.12 0.15 S S 0.92

Finally, to determine whether the adjustment of variables is toward their long-

run equilibrium values, estimates of δ0- δ 3 are used to construct an error-

correction term, say, ECM. Then lagged level variables in (2) are replaced by

ECMt-i and the new model that includes ECMt-i is re-estimated one more time

(at the same lags as before). A significantly negative coefficient obtained for

ECMt-i will support adjustment toward long-run equilibrium or again,

cointegration among the variables. For more clear explanation and derivation
167

of these points see Bahmani-Oskooee(Bahmani-Oskooee and Harvey

2010)Bahmani-Oskooee and Harvey 2010 and Tanku (Tanku2008). Clearly,

most models enjoy this property as evidenced from a significantly negative

coefficient for ECMt-i which carries a significantly negative coefficient in all

models except in four countries of Argentina, Costa Rica, Jamaica and

Venezuela. However, as it is discussed above, the calculated F-statistic is

greater than its upper-bound critical value of 3.77 in 3 countries of Argentina,

Costa Rica and Jamaica.

Moreover, three additional statistics are also reported: the Lagrange multiplier

test (LM) for residual serial correlation; Ramsey's RESET test for functional

misspecification; and the Normality test based on a test of skewness and

kurtosis of residuals. For most countries, these statistics are less than their

critical values reported in Table 2, confirming autocorrelation free residuals,

correctly specified models, and normality of the errors. In addition, the

majority of the estimated models are stable as indicated by "S" under two

stability test statistics, i.e, CUSUM and CUSUMSQ, applied to the residuals of

each error-correction model. Finally, most of these models exhibit a

reasonable goodness of fit, reflected by the size of the adjusted R2.

4.3 The Relationship between Wage and Price

Since the researcher tested Alexander's theory in this chapter, it is important

to examine its main assumption of the long lag structure in the adjustment of

wages to inflation. This lag leads to income redistribution from fixed income

groups or relatively poorer groups of the economy, who have a high MPC, to

richer groups, who have a low MPC. Eventually, it is expected that inflationary

effects of currency depreciation affect both groups' consumption. In addition,

if the adjustment between inflation and wages does not take place in the

short-run, the wage earners who receive fixed incomes will be well behind the
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entrepreneurs, whose profits have already been increased by inflation.

However, in the long run, the wages and prices might catch up and wages

may rise to restore the pre-devaluation wage-profit relationship. To judge this

argument, the popular Wage-Price Philips curve model of Blanchard, Katz

(1997, 1999) is estimated in this section. In this model, the nominal wage rate

index is the dependent variable and variables such as unemployment rate,

labour productivity per hour and inflation are the independent variables. The

main reason behind estimation of the Wage-Price Philips curve in this

dissertation is to find out the adjustment time between inflation and wages

over the period 1975-2006 for as many countries as possible.

The Blanchard, Katz model developed over several decades of interest in

various factors influencing nominal wages. The relationship between

unemployment and change in the nominal wage rate was explained for the

first time by Philips (1958). This model, popular as the Philips-curve model,

played a crucial role in macroeconomic studies during the 1960s and 1970s.

However, incorporating more variables, such as the inflation expectations,

into the original Philips-curve model increased its explanatory power and

made it applicable longer. Meanwhile, in a series of important studies and

influential contributions, David Blanchflower and Andrew Oswald (1994, 1995)

look at the empirical foundations of the Philips curve. Relying on micro wage

regressions which illustrate a minor auto-regression in real wages and making

inflation as a function of the unemployment rate, they question the credibility

of the Philips-curve model. Some authors, such as Oliver Blanchard and

Lawrence Katz (1997, 1999), challenge Blanchflower and Oswald's argument

on the downward bias of real wage auto-regression. Furthermore, Blanchard

and Katz (1997, 1999) theoretically and empirically investigate the role of an

error-correction wage share influence. Meanwhile, Plasmans, Meersman, van

Poeck and Merlevede (1999) used different approach. They consider the
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effect of the employment benefit system's generosity on the adjustment speed

of money wages, considering the demand pressure in the labour market.

Moreover, Gali, Gertler and Lopez- Salido (2001), Laxton, Rose and

Tambakis (1999) investigate inflationary expectations in their augmented

wage-price Philips-curve model.

The past decade has witnessed the emergence of a new popular framework

for monetary policy analysis, the so-called New Keynesian model. Following

Taylor (1980) and Calvo (1983), the Philips-curve literature has moved toward

another direction which is known as the New Keynesian Philips-curve.

Clarida, Gali and Gertler (1999) use this model in derivation of principles on

monetary policy that were criticized by Mankiw (2001). According to Mankiw,

despite the sticky prices in this model, the inflation rate changes rapidly. It is

worth noting that Gordon (1997), in his empirical study, gives a higher

importance to 'inflation inertia'.

Under the assumption of a constant natural rate of unemployment, Gali

derives a structural wage equation and shows the comovement of wage

inflation with the unemployment rate in the U.S. economy.

To examine the adjustment time between inflation and wages as the main

assumption of Alexander's theory, the next section uses the Blanchard, Katz

(1997, 1999) wage-price Philips-curve model estimated for both the short run

and the long run over the period 1975-2006.

4.4 The Model

To estimate the long-run relationship between the dependent variable and the

independent variables, equation (4.1) has been defined as a simple model in

log-linear form. Here, Wt is the nominal wage, P1 is the average price level,

Utis the unemployment rate, and At is labour productivity per hour. The

estimated coefficient of β is expected to be positive, γ negative and φ positive.


170

lnWt=α+βlnPt+γlnUt+φlnAt+εt (4.1)

Since the main purpose of this chapter is to distinguish the short-run effects of

inflation on nominal wage from its long-run effects, equation(4.1) specifies

equation (4.2) in an error-correction form using Pesaran et al.’s (2001)

bounds- testing approach.

∆LnWt = a+i=1n1bi∆LnWt-i+ i=0n2ci∆LnPt-i+i=0n3di∆LnUt-

0+i=0n4ei∆LnAt=i+δ0 LnWt-1 +δ1LnPt-1 +δ2LnUt-1 +δ3LnREt-1 +Vt (4.2)

The short-run effect of changes in average price level on nominal wage is

obtained by the estimates of ci’s and its long-run effects by the estimate of φ

that is normalized on φ0. The long-run effects would be meaningful if the

lagged-level variables as a proxy for the lagged-error term from (4.2) are

jointly significant (i.e., cointegrated) using, again the F-test.

4.5 The Empirical Results

For wage equation, annual data over the period 1975-2006 was available

from the sources mentioned in previous section. The main restriction for

extending the list of countries beyond the current sample was unavailability of

wage index and unemployment rate. A maximum of four lags are imposed on

each first-differenced variable in each model and Akaike's information

criterion (AIC) is used in selecting the optimum models. The results from each

model are reported in Tables.

Table 3: Short-Run and Long-Run Coefficient Estimates of Wages

Philips Curve
Country Short-Run coefficient Estimate Long-Run coefficient Estimates

∆LnPt ∆LnPt+1 ∆LnPt+2 ∆LnPt+3 Constant LnP LnU A


Philippines 0.29(3.03) -0.51(4.06) -0.57(4.06) -0.29(1.88) -0.20(0.95) 1.25(24.44) -0.39(2.23) 0.01(2.41)

Singapore -6.75(1.62) 6.13(2.23) 1.66(1.92) 0.71(0.21) 0.05(3.67)

Spain 0.44(1.66) -0.39(1.36) 0.54(1.83) 0.52(3.34) -0.65(0.83) 1.18(7.96) -0.06(2.26) 0.01(7.54)

Sri Lanka 2.22(6.21) -0.81(2.22) -14.11(20.56) 3.61(29.31) 0.76(0.81) -0.01(0.45)

Sweden 2.11(1.06) 3.47(1.45) -12.25(0.76) 1.79(5.43) 1.51(0.53) 0.53(3.25)

UK 0.65(4.62) 0.23(1.39) 0.25(1.34) 0.73(4.21) -0.28(0.63) 1.12(13.55) -0.22(3.19) 0.18(2.24)

US 0.30(3.27) 0.19(1.31) 5.69(0.18) 0.73(0.47) -2.89(2.01) 0.17(3.21)


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Considering Table 3, which reports the results for the short-run effects of

inflation on the nominal wage rate in each country, there is evidence that at

the 5% significance level there are 4 countries with at least one significant

short-run coefficient, implying that inflation affects wages in the short run. The

list includes U.K. and U.S. Out of these countries, the estimated coefficient is

negative and significant in countries, supporting the argument that inflation

negatively affects the wages in the short run. The short-run effects have

lasted into the long run. The long-run results show that, at the 5% confidence

level, the inflation rate has a significant effect on wages in 2 countries and is

expectedly positive in all cases, again supporting the argument that the

relationship between wages and prices will be restored and that they will

catch up in the long run. Moreover, the long-run results show that in 4 of 6

countries in the sample the unemployment rate (Ln U) carries a significant

negative coefficient implying that there is an inverse relationship between

unemployment rate and nominal wage rate. In these countries, the estimated

long-run coefficient for unemployment rate is insignificant. Asthe effect of

labour productivity per hour (Ln A), in these countries in the sample (UK, US

and Canada), exhibit a significant estimated coefficient. This estimated

coefficient is positive in all the countries implying that labour productivity has a

positive impact on the nominal wage rate in these countries. However, these

long-run effects would be meaningful only if the variables in the model are

cointegrated.

The results of the F-test and other diagnostics are reported in Table 3. This

result reveals that the F-statistic for joint significance of lagged variables, or

for their cointegration, is greater than its critical value of 4.14 in these

countries. However, since ECMt-i is significantly negative in the cases of

Belgium, Chile, Korea, Spain and Sri Lanka, these five countries are added to
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the list, making it possible to conclude that there is evidence of cointegration

in 2 countries.

Furthermore, the long-run result shows that the estimated coefficient for the

inflation rate is insignificant in eight countries (Australia, Colombia, Finland,

Mexico, Philippines, UK, US and Spain), thus not supporting Alexander's

theory.

Based on these results, it would be concluded that, over the study period

1975-2006, a significant relationship between inflation and wages has been

observed in the majority of countries in the sample. These findings show the

significant short-run effects of domestic prices on wages in 24 of 29 countries

included in this study, implying that the link between these two variables is

defensible. Furthermore, supporting Alexander's argument that wages will

eventually catch up with prices in the long run, the long-run results show that

there exists a significant positive relation between domestic price changes

and inflation in 21 of 29 countries. However, the estimated coefficient for the

remaining 8 countries in the sample is insignificant, contradicting Alexander's

theory. This might be explained by the possibility that the estimation period is

not long enough for these countries to allow wages adjust to inflation or that

there are wage-price rigidities in these countries that slow down the

adjustment process.

4.6 Domestic Investment

Most of the existing empirical works on the determinants of investment have

focused on the two main models of Jorgensen (1963) and Tobin (1969).

Jorgensen's (1963) early work has served as a base for several later works.

Examples are Abel and Blanchard (Blanchard and Katz 1997)Blanchard and

Katz 1997, Fazzari et al. (1988), Chirinko and Schaller (1995), Worthington

(1995), and Chirinko et al. (1999). Based on Jorgensen's model (1963), the
173

level of investment is related to the capital output ratio and the real cost of

capital. In his optimization model, actual investment at time t is a weighted

function of movements to the optimal capital stock in the previous periods.

This structure became highly controversial in the literature, because it leads to

auto-correlated error terms, making the model empirically unstable. This

theory is more about optimal capital and, therefore, it performs extraordinarily

poorly at the empirical level.

The second type of commonly used models is based on Tobin's Q (1969). In

this model, changes in investment relate to changes in the ratio of a firm's

equity value to the replacement cost of capital. Additionally, a number of other

studies in 1990s looked at the impact of other factors, such as uncertainty, on

investment (Driver and Moretón (1991), Ferderer (1993) and Price (1996)).

Most traditional research on investment has emphasized Net Present Value

(NPV) as a measure of whether a firm invests or not. Based on this argument,

a firm will invest if the expected NPV is positive and will not invest if it is

negative. This seems to be an oversimplified rule to determine the investment

decision. On the other hand, there has always been an argument about the

effects of inflation and exchange rate uncertainty on investment decisions.

The presence of uncertainty usually causes investors to wait rather than to

invest immediately. One famous paper that considered this as a factor in

investment decisions was by Dixit and Pindyck (1994). They evaluated the

option value of an investment project which, according to them, is the value of

waiting for investment. They limit their model to the effect of Net Present

Value on investment decisions. Derby, Hughes, Ireland and Pisciteli (1999)

later developed a model based on Dixit and Pindyck’s model. They

questioned threshold effects on investment decisions and tried to clarify the

types of industries that would gain and lose, respectively, as a result of this

volatility. They estimated an aggregate investment equation for France,


174

Germany, Italy, U.K, and the U.S. and tested both Jorgensen's model and

Tobin's Q.

The effect of uncertainty on investment has also been examined by several

other economists in the recent years. For example, Wong (2007) looks at the

effect of uncertainty on investment timing in a real option model, and shows

that for relatively safe projects, greater uncertainty shortens the expected

exercise time and thus increases the investment level. This conclusion is not

similar to the negative investmentuncertainty relationship, which has been

seen in extended literature. This conclusion regarding the positive relationship

between investment and uncertainty is correct only for high growth projects.

Interestingly, other than a few papers written by Goldberg (1993, 1995, 1999)

and Blecker (2007, 2009) the effect of exchange rate on investment has not

received enough empirical attention. In her 1993 and 1999 works, Goldberg

looks at the impact of exchange rate variability on investment activity for

manufacturing industries at the two digit level of industrial aggregation for the

U.S, Japan, U.K and Canada. She shows that investment responsiveness to

exchange rate uncertainty varies over time: positively with respect to

sectorialreliance on export share and negatively with respect to the share of

imported inputs in production. Blecker's way of looking at this relationship is

quite different than Campa and Goldberg's (1995, 1999). The main reasons

for this difference are the methodologies and different level of data

aggregation. He uses aggregate data for 1973-2004 to analyse the effects of

the real value of the dollar on investment in United States domestic

manufacturing. In his study, net profits for cash flow are measured in levels as

standard proxies for financial/liquidity constraints. He shows that these

variables are significantly affected by the exchange rate in the U.S.

manufacturing sector. His findings indicate that the effect of exchange rate on

investment occurs mainly through the financial or liquidity constraint channel.


175

He eventually argues that real appreciation of the dollar since 1995 has hurt

U.S. manufacturing investment. Based on Blecker's (2007) study, U.S.

manufacturing investment and the capital stock would have been much higher

in 2004 if the dollar had not appreciated after 1995. He shows that in US

manufacturing, investment would have been 61% higher and the capital stock

would have been 17% higher in 2004 if the dollar had not appreciated after

1995.

In his most recent study, Blecker (2009) estimates an investment function in

which Mexico's growth rate, real interest rate, real oil prices, and the real

exchange rate are the main determinants of investment. His findings indicate

that the real value of the peso has a positive direct effect on investment.

However, this effect was cancelled by the contractionary effects that the

exchange rate has on Mexico's growth rate.

4.7 The Model

The main purpose of this chapter is to investigate the impact of currency

depreciation on domestic investment by including the exchange rate in the

investment function. The basic set up in this part is similar to the models in

chapter two of this thesis. Following the main argument of this dissertation,

the real investment is a function of the real income, nominal interest rate and

real exchange rate. The long run investment function, therefore, takes the

following form:

lnIt=α+βlnyt+γlnrt+φlnREt+εt (4.3)

Where I is real investment; Y is real income, r is the nominal interest rate; and

RE is the real exchange rate. Based on the theory, if wages do not adjust to

the inflationary effects of devaluation, income is redistributed in real terms

from workers to producers in the form of higher profit. The high profit could

give incentive to producers, who will be more optimistic about future business
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opportunities and will invest more. Thus, it is expected that higher income

level leads to higher investment and an estimate of β will be positive. Since

an increase in the interest rate r leads to a higher cost of borrowing, an

estimate of φ is expected to be negative. However, if the real depreciation

leads to an increase in the cost of imported inputs, the cost incurred by

declined profit will more than offset the gain due to income redistribution, and

the estimate of f could then be positive. Estimating (4.3) provides the long-run

effects of income, interest rate, and the exchange rate on investment. To

distinguish the short-run effects from the long-run effects, (4.3) is re-written in

an error-correction format. Therefore, we follow the bounds-testing approach

of Pesaran et al. (2001) and re-write (4.3) as (4.4):

∆LnIt = a+i=1n1bi∆LnIt-i+ i=0n2ci∆LnYt-i+i=0n3di∆Lnrt-

0+i=0n4ei∆LnREt=i+δ0 LnIt-1 +δ1LnYt-1 +δ2Lnrt-1 +δ3LnREt-1 +Vt (4.4)

Equation (4.4) expresses (4.3) in an error-correction modelling format by

adding a linear combination of the lagged-level variables instead of the lagged

error-correction term.

The short-run effect of changes of real exchange rate on domestic investment

is assessed by the estimates of e,'s and its long-run effects by the estimate of

d3 that is normalized on d0. To verify the inclusion of the lagged-level

variables in (4.4), the F- test is applied for their joint significance. The long-run

effects would be meaningful if the lagged level variables as a proxy for lagged

error term from (4.3) are jointly significant. The F-table tabulated by Pesaran

et al. (2001) has new upper- and lower-bound critical values. To support joint

significance of all lagged-level variables which is interpreted as cointegration

among them, the calculated F-statistic must be greater than the upperbound

critical value. To determine whether the adjustment of variables is toward their

long-run equilibrium values, estimates of d0-d3 are used to construct an error-


177

correction term. Then lagged-level variables in (4.4) are replaced by ECM,.!

and the new model that includes ECM,.¡ is re-estimated (at the same lags as

before). As an alternative for the cointegration a significantly negative

coefficient obtained for ECMt.¡ will support adjustment toward long-run

equilibrium.

4.8 The Empirical Results

The error-correction model (4.4) is estimated using annual data for our period

of 1975-2006. Once again, a maximum of four lags on each variable are

imposed and Akaike's Information Criterion (AIC) is used to select the

optimum lags. The F-test is then carried out at optimum lags. The results are

reported in Tables 4. Table 4 report the short-run effects of currency

depreciation on domestic investment in our sample. The short-run coefficient

estimates in Tables 4 indicate that at the 10% level of significance, there is

clear evidence that there is at least one significant coefficient in the results for

43 countries implying that currency depreciation affects domestic investment

in the short run. Supporting Alexander's (1952) argument that a real

depreciation could stimulate domestic investment, the estimated short-run

results show that all significant short-run coefficients are negative.

Furthermore, the estimated significant shortrun coefficients are positive in the

cases of Brazil, Cameroon, Colombia, Costa Rica, Finland, France, Germany,

India, Italy, Japan, Jordan, Lesotho, Malaysia, Morocco, Pakistan, the

Philippines, Spain, Sweden, Tunisia, U.K., the U.S., and Venezuela, which

implies a real depreciation, lowering the real investment in these countries.

This could be explained by the fact that in these countries currency

depreciation raises the cost of imported inputs and results in a reduced profit;

hence reduced investment, as discussed before. Furthermore, the long-run

estimation results, reported in Tables 4 reveal that at the 10% level, exchange
178

rate changes have a significant effect in only 21 countries (Argentina, Brazil,

Cameron, Colombia, Finland, France, Germany, Indonesia, Ireland, Jamaica,

Kuwait, Malaysia, Morocco, New Zealand, Niger, Nigeria, Philippines , South

Africa, Spain, U.K. and Venezuela). While the long-run effect is negative in 10

countries (Argentina, Brazil, Cameron, France, Germany, Indonesia, Ireland,

Kuwait, Niger and U.K.), supporting Alexander (1952), it is positive in 11

countries (Colombia, Finland, Jamaica, Malaysia, Morocco, New Zealand,

Nigeria, Philippines, South Africa, Spain, and Venezuela), supporting

contractionary effects of depreciation on domestic investment, through the

higher cost of imported inputs. Obviously, it is expected that changes in real

income to be the major long-run determinant of investment and there is a

strong link between investment and the aggregate business cycle. As the

estimated results show, Ln Y carries its expected positive and significant

coefficient in almost every country. As the estimated coefficient for another

main determinant of investment function, interest rate carries a significant

long-run coefficient in half of the countries and in the majority of them that

estimate is unexpectedly positive.


Panel A: Short-run Coefficient Estimates
Variables Lag order
0 1 2 3
∆LnY 1.75(1.15) -3.21(1.57) -2.33(1.32) -3.07(2.22
∆Lnr 0.27(2.68) -0.26(2.26) -0.19 (1.73)
∆LnER -0.02(0.11) 1.01(3.05) 0.69(1.77) 0.55(1.91)
Panel B: Long-run Coefficient Estimates
Constant LnY LnER Lnr
12.78(15.47) 3.67(30.13) 0.87(7.34) 0.41(7.78

As the results of Beccarini's (2007) study show, the positive relationship

between interest rate and investment might exist. According to him, a positive

association between interest rate and investment is possible due to the

variance of interest rate is positively related to the level of interest rate and to

the level of investment. Furthermore, it is possible for interest rate to reflect

rate of return on investment, justifying the positive association. Shifting to the

table 104 and looking at the results of the F-test for joint significance of

lagged-level variables at optimum lags, the calculated F-statistic is greater


179

than the upperbound critical value of 3.77 supporting cointegration. A

significant negative coefficient for ECM also implies that the adjustment of

variables in almost all of these countries is toward their long-run equilibrium

values.

This whole section needs reformatting.

You mix up methodology issues with data analysis, you use so many differnet

models and you present them in different ways. Idon't really see what tests

are you performing to measure the realiability of your regression analysis.

Keep this in terms of structure simple

Regression results  test results  explanation of tables  is that what you

expected to find? And why?


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CHAPTER FIVE

50 CONCLUSION AND SUMMARY

The open economy macroeconomic mechanism and international trade

provide a strong correlation between exchange rate changes, domestic

consumption and domestic investment behavior. Alexander (1952) was

perhaps the first to highlight this link through introduction of absorption

approach to the trade balance. He argued that the only way devaluation could

improve the trade balance is by reducing domestic consumption and

increasing domestic investment so that more could be exported, leading to an

improvement in the trade balance. If wages do not adjust fully to inflation,

workers with high MPC will lose, and capital owners with low MPC will gain.

The overall impact will be a decline in aggregate consumption. As an attempt

to test Alexander's (Alexander 1952)Alexander 1952 hypothesis, this

dissertation relies on a simple aggregate consumption and investment

functions in which the real exchange rate as another determinant of

consumption and investment in addition to real income and interest rate, is

included in the models. Since wages may not adjust to inflation in the short

run but they do so in the long run, a methodology that distinguishes the short-

run effects of depreciation on consumption and investment from its long-run

effects has been used. In addition, to distinguish the short-run effects of

currency depreciation on consumption and investment from its long-run

effects, the models are specified in an error-correction form and applied

Pesaran et al. 's (2001) bounds testing approach.

By employing the bounds-testing approach to cointegration, the main

hypothesis for 50 countries is tested. In most countries, there is an evidence

of the significant effect of exchange rate on consumption and investment in


181

the short run but not in the long run. This is consistent with the expectation as

wages do not adjust to inflation in the short run but they do in the long run. Or,

on the other hand, it might be an evidence for the fact that the idea of older

sticky-price Keynesian models can be violated at least for the long-run

models. However, another explanation for this finding might be that estimation

period for these countries is not long enough during which wages adjust to

inflation.

The estimated results of the consumption model shows that the short-run

effects last into the long run only in 21 countries. Again, this may imply that

either for these countries our estimation period is not long enough during

which wages adjusts to inflation or in these countries there are wage-price

rigidities that slow down the adjustment process. Furthermore, while in nine

countries the coefficient estimate is positive supporting Alexander, in 13

countries it is negative, rejecting him. Considering the investment model, this

research found a significant short-run effect of currency depreciation on

domestic investment in 43 out of 50 countries included in this study, implying

that the link between domestic investment and the exchange rate is

unavoidable. However, the short-run effects lasted into the long run only in 21

countries.

While in 10 countries depreciation resulted in an increase in domestic

investment supporting Alexander's argument, in 11 countries it resulted in a

decrease, supporting the alternative view. Long adjustment time between

wages and inflation plays a key role in this theory. Finally, as an attempt to

show the relationship between wages and inflation both in the short run and

the long run; I estimated the Blanchard-Katz (1997-1999) Wage-Philips curve

model for a group of countries whose data was available. Based on the

estimated results, inflation has a negative significant effect in most cases in

the short run but not in the long run. Out of these 24 countries, the estimated
182

coefficient is negative and significant in 15 countries, supporting the argument

that inflation negatively affects the wages in the short run. In 21 of the 24

countries, short-run effects have lasted into the long run. The long-run results

show that the inflation rate has a significant effect on wages in 2 1 countries

and is expectedly positive in all cases, again supporting the argument that the

relationship between wages and prices will be restored and that they will

catch up in the long-run.

Where is your abstract?

Where is your title?