Effect of interest rate on consumption under alternative expectations hypotheses: evidence from Pakistan.I. Introduction
The effect of the interest rate on consumption behavior has been subject to controversy. Before Keynes (1936), the interest rate was considered to be the prime determinant of savings. Keynes demonstrated that fluctuations in the short run interest rate had no significant effect on spending decisions. Kuznets (1946) reported that the savings rate Savings rate
Personal savings as a percentage of disposable personal income. remained stable over the long run. However, in Modigliani's (1953) life cycle hypothesis The Life Cycle Hypothesis (LCH) is an economic concept analysing individual consumption patterns. It was developed by the economists Irving Fisher, Roy Harrod, Alberto Ando and Franco Modigliani. (LCH LCH Launch
LCH London Clearing House
LCH Langerhans Cell Histiocytosis (medicine; immune system disorder)
LCH Light Combat Helicopter
LCH Lake Charles, LA, USA - Municipal (Airport Code) ), the interest rate played an important part in measuring the consumer's expected future earnings and net worth which, in turn, influenced consumption behavior. In Friedman's (1957) permanent income hypothesis The permanent income hypothesis (PIH) was developed by the American economist Milton Friedman. In its simplest form, PIH states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term income expectations. (PIH PIH
prolactin-inhibitory hormone. ), the rate of interest became a major determinant of the marginal propensity to consume The marginal propensity to consume (MPC) refers to the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). out of permanent income.
More recently, Wright (1967) and Heien (1972) estimated a negative and significant relationship between the interest rate and consumption expenditure. In contrast, Weber (1970) and Springer (1975) reported a positive and significant effect of the interest rate on consumption. Also, Boskin (1978) estimated a substantial interest elasticity of savings. Feldstein (1970) demonstrated that studies using the nominal instead of the real interest rate were subject to a serious specification bias. Carlino (1982) employing four different interest rates estimated contradictory signs for the interest rate coefficients and rejected the hypothesis that variations in the real interest rate altered consumption decisions. Likewise, Blinder and Deaton (1985) and Campbell and Mankiw (1989) estimated an insignificant effect of the real interest rate on consumption.
In this paper, we examine the effect of the real interest rate on consumption behavior in Pakistan, taking into consideration the presence of money market imperfections. Thus, alternative proxies for the opportunity cost of holding real balances are considered to test the sensitivity of the consumption function to the changing money market conditions. Section II discusses issues related to estimating the consumption function and to the structural characteristics of money markets in the developing countries. Section III outlines the theory of consumption function. Section IV presents the empirical results and Section V includes the concluding remarks.
II. Relevant Issues
Development of the theory of consumption function has been fascinating but controversial. For a long time, both the theoretical derivation and the econometric framework of the aggregate consumption function were considered settled. Most economists adhered to one of two ways of putting Fisher's theory of intertemporal optimization into cooperation: the PIH or LCH. Since each variant had sound theoretical construct, and since they had similar econometric forms that could explain the data well and had similar policy implications, there was not a great deal of controversy about. However, development in economic research have raised fundamental questions about the theory of consumption function. Some recent theoretical development included the Barro's equivalence hypothesis (1974), Lucas' critique (1976), Hall's random walk hypothesis The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It has been described as 'jibing' with the efficient market hypothesis. (RWH RWH Rain Water Harvesting
RWH Return With Honor
RWH Radar Warning & Homing
RWH Read and Write Hold Time ) (1978), as well as flexible approaches by Giovannini (1985) and Blinder and Deaton.
Hence, a complementary goal of our investigation of the relationship between consumption and the real interest rate is to test the fit of the standard consumption models against that of their recent challenges to Pakistan's data. For a secondary issue as such, it may be suffice to focus on only two alternative formulations of the consumption function, for example, PIH and RWH that quarrel about the nature of income expectations.
Another important issue is the meaningfulness of the observed interest rate in the developing countries. In general, the observed interest rate may not correctly reflect the cost of holding money since there exist: (1) institutional rigidities and regulations which set the interest and discount rates; (2) unorganized money markets which yield substantially higher interest rates; (3) and immature financial markets which offer a limited range of alternative assets Alternative Assets
A term referring to non-traditional assets with potential economic value.
Examples of alternative assets include art and antiques, precious metals, fine wines, rare stamps and coins, and other collectibles such as sports cards. to the wealth holders. Under such conditions, physical assets represent the most common form of wealth holding. If readily liquidable, they constitute close substitutes for real balances. Thus, the expected rate of inflation Expected rate of inflation
The public's expectations for inflation. These expectations determine how large an effect a given policy action by the Fed will have on economic activity. , instead of the rate of interest, becomes an appropriate indicator of the rate of return on assets Return on assets (ROA)
Indicator of profitability. Determined by dividing net income for the past 12 months by total average assets. Result is shown as a percentage. ROA can be decomposed into return on sales (net income/sales) multiplied by asset utilization (sales/assets). (see e.g. Nugent, and Glezakos, 1979).
In general though, the effect of unanticipated and variable inflation on the consumer demand is ambiguous. Workers, who expect their nominal incomes fail to keep up with inflation, try to spend less. To the extent that they treat higher inflation as a sign of hard times to come, inflationary expectations cause consumption expenditure to decline. However, expectations of higher inflation may have the opposite effect. Higher prices translated into reduced purchasing powers increase the level of aggregate demand as consumers spend more rapidly. They may decide to buy before prices rise. If the "purchasing power" effect predominates the "hard times" effect, then expectations of accelerating inflation will stimulate, rather than depress, the aggregate demand (see e.g., Dolan, 1980, 134-).
Also, the degree of credit restraint may be a proxy for the interest rate as there exist certain links between the organized and unorganized money markets, and since borrowing is still a means of financing transactions. Due to the negligibility of the speculative money demand and pegging of the interest rate, the observable interest rates cease to be the key linkage between holding money and interest bearing assets. Instead, interest rates in the unorganized markets, although unobservable, reflect the degree of credit restraint in an economy. Wong (1977) suggested that, in the developing countries, where interest rates are inoperative Void; not active; ineffectual.
The term inoperative is commonly used to indicate that some force, such as a statute or contract, is no longer in effect and legally binding upon the persons who were to be, or had been, affected by it. , the degree of credit restraint can approximate the opportunity cost of holding real balances. His experimentation with various measures of the degree of credit restraint used in the demand for money function demonstrated that the negative of domestic credit to income ratio and one less the ratio of domestic credit to income are generally applicable.
In our empirical examination, thee PIH and RWH consumption models are estimated to determine the effect of the observed real interest rate or its proxy variables on consumption.
III. Consumption Model
In the PIH, permanent consumption is proportional to permanent income. (1) [Mathematical Expression A group of characters or symbols representing a quantity or an operation. See arithmetic expression. Omitted] where, the factor of proportionality Noun 1. factor of proportionality - the constant value of the ratio of two proportional quantities x and y; usually written y = kx, where k is the factor of proportionality
constant of proportionality depends on the real rate of interest r ([Delta]k/[Delta]r<0), the ratio of human to nonhuman capital w ([Delta]k/[Delta]w<0), and consumer taste u for current consumption or savings and hence for future consumption. Permanent income and consumption are unobservable and therefore correspondence must be established between them and measured income and consumption, (2) [Mathematical Expression Omitted] (3) [Mathematical Expression Omitted] Transitory TRANSITORY. That which lasts but a short time, as transitory facts that which may be laid in different places, as a transitory action. income and transitory consumption are random components of measured income and consumption [Mathematical Expression Omitted]. There is expected to be no correlation between permanent and transitory income, permanent and transitory consumption, and transitory income and transitory consumption, (4) [Rho] ([Y.sup.P], [Y.sub.T]) = [Rho] ([C.sup.P], [C.sup.T]) = [Rho] ([Y.sup.T], [C.sup.T] = 0 In particular, zero correlation between transitory income and transitory consumption implies that transitory income is saved to form capital or is spent on consumer durables Consumer durables
Consumer products that are expected to last three years or more, such as an automobile or a home appliance.
See durable goods. . In the "strict" form of the PIH, all of the consumption increase is explained by the increase in permanent income. In the "modified" PIH, the marginal propensity to consume out of transitory income is positive, but smaller than the marginal propensity to consume out of permanent income [e.g., Laumas and Laumas (1976)]. Accordingly, consumption is a function of both permanent and transitory income, (5) [Mathematical Expression Omitted]
To investigate the effect of the interest rate on consumption behavior, Carlino expresses the marginal propensity to consume out of permanent income as a linear function of the real interest rate, (6) [k.sup.P] = a + [br.sub.t] Substitute (6) in (5), the consumption function becomes (7) [Mathematical Expression Omitted] Carlino's sensitivity test of (7) consists of the comparison between estimation results of (7) with those from a regression in which the real interest rate directly affects consumption, (8) [Mathematical Expression Omitted]
Since the PIH places great importance on the current period expectations of future income, the process of expectations formation plays a central role in the analysis of consumption behavior. Originally, the adaptive expectations In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would revise expectations for the future. hypothesis is used to generate values for unobservable permanent and transitory income by estimating income weights from a geometrically declining distributed lag function of past levels of the observed income (see Friedman).
Hall argues that empirical research Noun 1. empirical research - an empirical search for knowledge
inquiry, research, enquiry - a search for knowledge; "their pottery deserves more research than it has received" on the LCH and PIH is seriously weakened by failing to take proper account of the endogeneity of income, which is the major independent variable in these consumption functions. Begg (1982) formulates the rational expectations RWH consumption behavior by assuming that households lend or borrow at a constant real rate of interest [Delta]. Denoting [W.sub.t] as the current period real wealth and [Mathematical Expression Omitted] as rational expectations of future incomes conditional on current information, permanent income is defined as (9) [Mathematical Expression Omitted] Considering that households at the time (t - 1) form expectations conditional on information available at this time, expectations of permanent income is (10) [Mathematical Expression Omitted] By definition of permanent income as a constant stream that households envisage over the planning horizon Planning horizon
The length of time a model or investor or plan projects into the future. , it must be true that (11) [Mathematical Expression Omitted] Substitute (11) in (10) and subtract that from (9), (12) [Mathematical Expression Omitted] Noting that each and every term in the right hand side is a pure rational expectations forecast error, rewrite (12) as (13) [Mathematical Expression Omitted] Where [u.sub.t] is a white noise random variable. Equation (13) implies that individuals ought not to expect their permanent income to change, for if it did, this knowledge should already have been used to reassess permanent income.
To derive the RWH consumption function, lag (1) by one period, subtract that from (1) and then apply (13), (14) [C.sub.t] = [C.sub.t-1] + [V.sub.t] where [v.sub.t] = [ku.sub.t] is also white noise random variable. Accordingly, consumption follows a random walk behavior, implying that the best guess about future consumption is the current period consumption because it is based on the latest assessment of permanent income, which embodies all available information at the time of forming expectations. In the random walk test of consumption behavior, up to four period lagged values of variables such as consumption expenditure, observed income, or the real interest rate are added to (14), (15) [Mathematical Expression Omitted] (16) [Mathematical Expression Omitted] (17) [Mathematical Expression Omitted] Hypothesis testing hypothesis testing
In statistics, a method for testing how accurately a mathematical model based on one set of data predicts the nature of other data sets generated by the same process. of the presence of irrelevant variables (t-test) and joint test on several regression coefficient Regression coefficient
Term yielded by regression analysis that indicates the sensitivity of the dependent variable to a particular independent variable. See: Parameter.
regression coefficient (F-test) are performed [Pindyck and Rubinfeld (1981: 130-131 and 117-119)]. The random walk behavior is observed if the estimated coefficient of one period lagged consumption does not vary significantly from one, while coefficients of other lagged variables included in (15)-(17) do not significantly vary from zero.
IV. Empirical Results
Data include annual observations on private consumption expenditure and disposable personal income expressed in 1960 prices and per capita [Latin, By the heads or polls.] A term used in the Descent and Distribution of the estate of one who dies without a will. It means to share and share alike according to the number of individuals. values for the 1953-84 period. The long run government bonds interest rate is deflated de·flate
v. de·flat·ed, de·flat·ing, de·flates
a. To release contained air or gas from.
b. To collapse by releasing contained air or gas.
2. to represent the real interest rate. The rate of inflation is computed as the percentage change of the implicit GNP GNP
See: Gross National Product deflator Deflator
A statistical factor used to convert current dollar purchasing power into inflation-adjusted purchasing power. Enables the comparison of prices while accounting for inflation in two different time periods. over its previous period. Main sources of data included Statistical Yearbook for Asia and Pacific, Pakistan Economic Survey, Report on Currency and Finance, and various reports of State Bank of Pakistan The State Bank of Pakistan (SBP) is the central bank of Pakistan. While its constitution, as originally laid down in the State Bank of Pakistan Order 1948, remained basically unchanged until January 1, 1974, when the bank was nationalised, the scope of its functions was and 20 Years of Pakistan in Statistics (for more detailed explanation see Ghouri, 1986).
The observe variables in the consumption function models are:
C: Consumption expenditure
Y: Disposable personal income
i: Inflation rate The measure of credit constraint, as suggested by Wong, does not seem to be appropriate and, therefore, is not considered. The degree of credit restraint is likely to be exogenous Exogenous
Describes facts outside the control of the firm. Converse of endogenous. . In particular, the level of domestic credit itself is highly influenced by the GNP and other macroeconomic mac·ro·ec·o·nom·ics
n. (used with a sing. verb)
The study of the overall aspects and workings of a national economy, such as income, output, and the interrelationship among diverse economic sectors. variables. Hence, the negative domestic credit-income ratio, for instance, will not accurately measure the opportunity cost of holding money and may generate biased estimates.
The adaptive expectations PIH consumption functions (5), (7), and (8) are estimated by first or second degree serial correlation serial correlation
The relationship that one event has to a series of past events. In technical analysis, serial correlation is used to test whether various chart formations are useful in projecting a security's future price movements. procedures, whenever necessary. The Almon procedure is used to estimate the appropriate weights in generating values for the unobservable permanent and transitory incomes and expected inflation rate. Best weights are obtained from a polynomial polynomial, mathematical expression which is a finite sum, each term being a constant times a product of one or more variables raised to powers. With only one variable the general form of a polynomial is a0xn+a distributed lag model with degree one and length three subject to a tail restriction.(1) Table 1 presents the estimation results. In all equations, the autonomous consumption Autonomous consumption is a term used to describe consumption expenditure that occurs when income levels are zero. Such consumption is considered autonomous of income only when expenditure on these consumables does not vary with changes in income. is insignificant, indicating the existence of a long-run consumption relationship. Coefficients of both permanent and transitory income variables are significantly different from zero and one. But, the marginal propensity to consume out of permanent income is close to unity and larger than that of transitory income. This result supports the "modified" PIH in which some of the transitory income is consumed. The estimate coefficient of the real interest rate (r) or expected inflation rate ([i.sup.e]) on consumption is insignificant. This result indicates that the "purchasing power" and "hard time" effects of inflation offset each other, generating no significant net impact on the level of aggregate demand. [Tabular Data 1 Omitted]
The rational expectation RWH consumption functions (14)--(17) are estimated to test a joint null hypothesis null hypothesis,
n theoretical assumption that a given therapy will have results not statistically different from another treatment.
n claiming that the coefficient of one period lagged consumption is one, while coefficients of all other variables lagged are equal to zero. Table 2 presents the estimation results. No evidence of serial correlation is present as indicated by values of the Durbin-h statistic. In all regression equations, the estimated coefficient of the one period lagged consumption is close to unity and the null hypothesis that this coefficient is equal to one cannot be rejected. Coefficients of additional lagged consumption or income are significant, indicating that consumption follows a random walk behavior. Once again, the estimated coefficient of the real rate of interest or the expected rate of inflation is statistically insignificant. These alternative measures of the cost of holding money are viewed as irrelevant variables in the RWH consumption function.(2) The efficiency loss from the inclusion of these irrelevant variables does not greatly influence the significance of the one period lagged consumption parameter. In the joint test involving coefficients of the additional variables, the null hypothesis that their coefficients equal to zero is accepted as values of the computed F-statistic are all smaller than their critical values. [Tabular Data 2 Omitted]
Our complementary findings are that both the adaptive expectations PIH and rational expectations RWH fit our data equally well and that the replacement of the real interest rate by the expected rate of inflation does not alter the empirical results.
Our estimation results of the consumption function present evidence that the real rate of interest has no effect on consumption behavior in Pakistan. This finding has important implications for domestic capital formation and income growth. An interest-insensitive consumption function in a low-income country such as Pakistan indicates that individuals are unwilling or unable to alter significantly their projected consumption path to take advantage of higher rates of return on interest bearing assets. No increase in the volume of domestic savings may occur and no additional resources may be released for investment in response to variations in the real interest rate. The likely response of the current account is thus, other things equal, a deficit due to the low savings-GNP ratio. Also, limited domestic capital formation hinders income growth in the absence of external financing In the theory of capital structure, External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. to fill in the savings-investment gap. such an interest-insensitivity is crucial in the case where the economy faces constraints on international indebtedness should the international lending institutions require higher real interest rates to increase savings of domestic residents and stimulate capital formation.
(1)The adaptive expectations hypothesis is used to generate predictions for income and inflation rate variables from polynomial distributed lag models of degree one and minimum lag length of three years with tail restrictions. Time-series on permanent income include the predicted values of the measured income and transitory income series are the residuals and time-series on expected inflation rate consist of the predicted values of actual inflation rates. (2)Coefficients of the fourth lagged real interest rate, as well as inflation rate are close to zero and thus not reported in Table 2.
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at Bakersfield. Salman Saif Ghouri, Colorado School of Mines Colorado School of Mines, at Golden; state supported, coeducational; chartered 1874. It was one of the first mineral engineering schools in the United States. at Golden.