External Shocks and High Volatility in Consumption in Low-Income Countries

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Abstract

According to the well-known concept of consumption smoothing, the volatility of consumption is low even when income is volatile; this is confirmed by data from G7 countries. Surprisingly, however, consumption volatility in many low-income countries is nontrivially higher than income volatility. Here I examine what causes high consumption volatility in low-income countries. In general, volatile consumption makes consumers worse off. Therefore, understanding the causes of high consumption volatility can contribute to improving welfare in low-income countries by suggesting measures to assist in the stabilization of consumption. Unlike much previous research, I focus on international factors when explaining high consumption volatility. The results suggest that external shocks, which are far more volatile in low-income countries than in industrialized countries, strongly swing consumption. By capturing these mechanisms, the model I use successfully accounts for consumption volatility's differences between the sample low-income country and sample industrialized country.

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