Effect of Interest Rate on Consumption under Alternative Expectations Hypotheses: Evidence from Pakistan

Article excerpt

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 remained stable over the long run. However, in Modigliani's (1953) life cycle hypothesis (LCH), 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 (PIH), the rate of interest became a major determinant of the marginal propensity to consume 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 (RWH) (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 to the wealth holders. …