The Effect of Change in Interest Rate On Consumption and GDP in UK

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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...........................................................................................
4.6 Domestic Investment...........................................................................
4.7 The Model.......................................................................................67
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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JtaW5hbnRzIG9mIGhv
BvZiBNb25leSwgQ3Jl
5nPC9mdWxsLXRpdGxl
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19
mVjTnVtPjxyZWNv
a2V5IGFwcD0iRU4i
iPjQ0PC9rZXk+PC9m
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dGxlcz48dGl0bGU+
dW1wdGlvbjogRXZp
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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0aG9yPkNhcmxpbm88
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MjwvaXNibj48YWNj
43
GU+QXJ0aWNsZTwvd29y
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01MDMwMDU4JmFtcDtz
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b2x1bWU+ODY8L3Zv
cj48L2RhdGVzPjxp
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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52
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WNvcmQ+PC9DaXRl
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cyk8L2tleXdvcmQ+
SIGdvb2RzPC9rZXl3
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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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MtbnVtYmVyPjU0PC9y
mZ3enJmOXQxd3Zw
XlzPjxyZWYtdHlw
pYnV0b3JzPjxhdXRo
Y29udHJpYnV0b3Jz
ZpZXc8L3NlY29uZGFy
GUgQW1lcmljYW4gRWNv
92
Rlcz48eWVhcj4xOTc1
wvdXJscz48L3JlY29y
WVhcj4xOTk2PC9ZZWFy
9yZWMtbnVtYmVyPjxm
MnJlcnZ4aDV2cjBw
SBuYW1lPSJCb29r
WxtZW5kb3JmLCBE
BGZWRlcmFsIFJlc2Vy
aXRsZXM+PHRpdGxl
aG9sZCBzYXZpbmcg
GRhdGVzPjx5ZWFyPjE5
NoZXI+PHVybHM+PC91
Ghvcj48WWVhcj4y
93
nVtYmVyPjk3PC9yZWMt
nJmOXQxd3ZwMnJl
xyZWYtdHlwZSBu
b3JzPjxhdXRob3Jz
YXV0aG9yPjwvYXV0
JtaW5hbnRzIG9mIGhv
BvZiBNb25leSwgQ3Jl
5nPC9mdWxsLXRpdGxl
YXRlcz48aXNibj4x
48Q2l0ZT48QXV0aG9y
mVjTnVtPjxyZWNv
94
a2V5IGFwcD0iRU4i
iPjQ0PC9rZXk+PC9m
+MTc8L3JlZi10eXBl
Ghvcj48YXV0aG9y
dGxlcz48dGl0bGU+
dW1wdGlvbjogRXZp
PC9yZWNvcmQ+PC9D aXRlPjwvRW5kTm90ZT5=
E5NzA8L1llYXI+PFJl
2ViZXIgMTk3MTsgU3By
9yZD48cmVjLW51bWJl
taWQ9Inpmd3py
VpZ24ta2V5cz48
95
GU+PGNvbnRyaWJ1dG9y
G9ycz48L2NvbnRyaWJ1
HJhdGVzIG9uIGFnZ3Jl
UgQW1lcmljYW4gRWNv
8L3BlcmlvZGlj
T48bnVtYmVyPjQ8L251
MDItODI4MjwvaXNi
+V2ViZXI8L0F1dGhv
JkPjxyZWMtbnVtYmVy
Yi1pZD0iemZ3enJm
ZWlnbi1rZXlzPjxy
8Y29udHJpYnV0b3Jz
0aG9ycz48L2Nv
96
gdGhlIFNob3J0LVJ1
ZT5BbWVyaWNhbiBF
yaW9kaWNhbD48ZnVs
GU+PC9wZXJpb2RpY2Fs
PjM8L251bWJlcj48
GtleXdvcmQ+Q09OU1VN
PC9rZXl3b3JkPjxr
NVTVBUSU9OIChF
eXdvcmQ+Qk9ORFMg
E5NzE8L3llYXI+PC9k
9wdWJsaXNoZXI+
wvYWNjZXNzaW9uLW51
C11cmxzPjx1cmw+
XRydWUmYW1wO2Ri
97
mw+PC9yZWxhdGVkLXVy
1kYXRhYmFzZS1uYW1l
UtZGF0YWJhc2UtcHJv
8L0F1dGhvcj48WWVh
MtbnVtYmVyPjU0PC9y
mZ3enJmOXQxd3Zw
XlzPjxyZWYtdHlw
pYnV0b3JzPjxhdXRo
Y29udHJpYnV0b3Jz
ZpZXc8L3NlY29uZGFy
GUgQW1lcmljYW4gRWNv
Rlcz48eWVhcj4xOTc1
98
wvdXJscz48L3JlY29y
WVhcj4xOTk2PC9ZZWFy
9yZWMtbnVtYmVyPjxm
MnJlcnZ4aDV2cjBw
SBuYW1lPSJCb29r
WxtZW5kb3JmLCBE
BGZWRlcmFsIFJlc2Vy
aXRsZXM+PHRpdGxl
aG9sZCBzYXZpbmcg
GRhdGVzPjx5ZWFyPjE5
NoZXI+PHVybHM+PC91
Ghvcj48WWVhcj4y
nVtYmVyPjk3PC9yZWMt
nJmOXQxd3ZwMnJl
99
xyZWYtdHlwZSBu
b3JzPjxhdXRob3Jz
YXV0aG9yPjwvYXV0
JtaW5hbnRzIG9mIGhv
BvZiBNb25leSwgQ3Jl
5nPC9mdWxsLXRpdGxl
YXRlcz48aXNibj4x
48Q2l0ZT48QXV0aG9y
mVjTnVtPjxyZWNv
a2V5IGFwcD0iRU4i
iPjQ0PC9rZXk+PC9m
100
+MTc8L3JlZi10eXBl
Ghvcj48YXV0aG9y
dGxlcz48dGl0bGU+
dW1wdGlvbjogRXZp
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
j4xOTY3PC9ZZWFyPjxS
mYXNvbiAxOTgxOyBT
WF0b24gMTk5MjsgRmV0
jUzPC9yZWMtbnVtYmVy
3ZwMnJlcnZ4aDV2
101
lwZSBuYW1lPSJK
XRob3JzPjxhdXRo
zPjx0aXRsZXM+PHRp
Hkgb2YgY29uc3VtcHRp
WljIFJldmlldzwv
dGxlPlRoZSBBbWVy
2FsPjxwYWdlcz44NTAt
W1iZXI+PGRhdGVzPjx5
HVybHM+PC91cmxz
cj48WWVhcj4xOTg0
yPjYyPC9yZWMtbnVt
OXQxd3ZwMnJlcnZ4
YtdHlwZSBuYW1l
PjxhdXRob3JzPjxh
102
M+PC9jb250cmlidXRv
VybiBBZmZlY3RzIFBy
48ZnVsbC10aXRsZT5B
2RpY2FsPjxwYWdlcz4y
cj48a2V5d29yZHM+
eXdvcmQ+Q0FQSVRB
ybjwva2V5d29yZD48
Q+RUxBU1RJQ0lUWSAo
QVElPTiAoRWNvbm9t
ZWFyPjwvZGF0ZXM+
GlzaGVyPjxpc2Ju
2lvbi1udW0+PHdv
103
Jscz48dXJsPmh0dHA6
lJmFtcDtkYj1idGgm
WJhc2UtbmFtZT48cmVt
GFiYXNlLXByb3ZpZGVy
cj48WWVhcj4xOTgx
VyPjYxPC9yZWMtbnVt
OXQxd3ZwMnJlcnZ4
WYtdHlwZSBuYW1l
PjxhdXRob3JzPjxh
M+PC9jb250cmlidXRv
W11bGF0aW9uIGluIGEg
104
GtleXdvcmQ+Q0FQ
tleXdvcmQ+PGtleXdv
Q+V0FHRVM8L2tleXdv
+PGtleXdvcmQ+RUNP
E8L3llYXI+PC9kYXRl
WJsaXNoZXI+PGlz
NjZXNzaW9uLW51bT48
mxzPjx1cmw+aHR0
WUmYW1wO2RiPWJ0
9yZWxhdGVkLXVybHM+
hYmFzZS1uYW1lPjxy
GF0YWJhc2UtcHJvdmlk
105
0aG9yPjxZZWFyPjE5
mVyPjEwMzwvcmVj
pyZjl0MXd2cDJy
eXM+PHJlZi10eXBl
XRvcnM+PGF1dGhv
V0aG9ycz48L2NvbnRy
RHVyYWJsZSBFeHBl
FyeS10aXRsZT5BbWVy
xlcz48cGVyaW9kaWNh
GwtdGl0bGU+PC9wZXJp
bnVtYmVyPjQ8L251
pPC9rZXl3b3JkPjxr
VU1FUiBiZWhhdmlv
2V5d29yZD48a2V5d29y
106
gZ29vZHMsIENvbnN1
GtleXdvcmQ+QVNT
8eWVhcj4xOTc2PC95
3NvY2lhdGlvbjwvcHVi
k5MjQ8L2FjY2Vz
+PHJlbGF0ZWQtdXJs
B4P2RpcmVjdD10cnVl
9yZW1vdGUtZGF0YWJh
wvcmVtb3RlLWRhdGFi
bGZhc29uPC9BdXRo
9yZD48cmVjLW51bWJl
taWQ9Inpmd3py
VpZ24ta2V5cz48
107
GU+PGNvbnRyaWJ1dG9y
XRob3I+PC9hdXRob3Jz
VTLCBJTkZMQVRJT04s
jb25kYXJ5LXRp
FY29ub21pY3Mg
Z2VzPjIzMzwvcGFn
b3Jkcz48a2V5d29y
4gKEZpbmFuY2UpPC9r
3JkPjxrZXl3b3Jk
kVTVE1FTlRTPC9r
3Jkcz48ZGF0ZXM+
zPC9wdWJsaXNoZXI+
wvYWNjZXNzaW9uLW51
108
C11cmxzPjx1cmw+
XRydWUmYW1wO2Ri
w+PC9yZWxhdGVkLXVy
1kYXRhYmFzZS1uYW1l
UtZGF0YWJhc2UtcHJv
C9BdXRob3I+PFllYXI+
y1udW1iZXI+MTAxPC9y
mZ3enJmOXQxd3Zw
2V5cz48cmVmLXR5
RyaWJ1dG9ycz48YXV0
bnRyaWJ1dG9ycz48
3JhbCBTdWJzdGl0dXRp
xkYXRlcz48eWVh
wvQ2l0ZT48Q2l0ZT48
109
051bT45OTwvUmVj
Z24ta2V5cz48a2V5
yd3JycjAyOTUiPjk5
gQXJ0aWNsZSI+MTc8
3RlaW4sIE1TPC9h
Y29udHJpYnV0b3Jz
gYW5kIHRoZSBwZXJz
RsZT5UaGUgUXVhcnRl
Vjb25vbWljczwvZnVs
2b2x1bWU+ODI8L3Zv
hcj48L2RhdGVzPjxp
C9DaXRlPjxDaXRlPjxB
VtPjEwMDwvUmVjTnVt
110
duLWtleXM+PGtleSBh
ycnIwMjk1Ij4xMDA8
cmVmLXR5cGU+PGNv
G9yPjwvYXV0aG9ycz48
NvbnN1bXB0aW9uPC90
zPjxwdWJsaXNoZXI+
AxOTgyODgyNDc8
0aG9yPkNhcmxpbm88
48cmVjb3JkPjxyZWMt
9IkVOIiBkYi1pZD0i
5PjwvZm9yZWlnbi1r
HlwZT48Y29udHJp
dXRob3I+PC9hdXRo
BVEUgRUZGRUNUUyBB
111
Gl0bGVzPjxwZXJp
m9taWNzPC9mdWxsLXRp
HVtZT45PC92b2x1bWU+
U9OIChFY29ub21p
wva2V5d29yZHM+
MjwvaXNibj48YWNj
GU+QXJ0aWNsZTwvd29y
NoLmVic2NvaG9zdC5j
01MDMwMDU4JmFtcDtz
HJlbW90ZS1kYXRhYmFz
ZD48L0NpdGU+PENp
xSZWNOdW0+NTU8L1Jl
112
aWduLWtleXM+PGtl
yMndycnIwMjk1Ij41
IEFydGljbGUiPjE3
a2luLCBNSjwvYXV0
UYXhhdGlvbiwgc2F2
RhcnktdGl0bGU+VGhl
sZT48L3RpdGxlcz48
b2x1bWU+ODY8L3Zv
cj48L2RhdGVzPjxp
9DaXRlPjwvRW5kTm90 ZT4A
j4xOTY3PC9ZZWFyPjxS
mYXNvbiAxOTgxOyBT
113
WF0b24gMTk5MjsgRmV0
jUzPC9yZWMtbnVtYmVy
3ZwMnJlcnZ4aDV2
lwZSBuYW1lPSJK
XRob3JzPjxhdXRo
zPjx0aXRsZXM+PHRp
Hkgb2YgY29uc3VtcHRp
WljIFJldmlldzwv
dGxlPlRoZSBBbWVy
2FsPjxwYWdlcz44NTAt
W1iZXI+PGRhdGVzPjx5
HVybHM+PC91cmxz
cj48WWVhcj4xOTg0
yPjYyPC9yZWMtbnVt
114
OXQxd3ZwMnJlcnZ4
YtdHlwZSBuYW1l
PjxhdXRob3JzPjxh
M+PC9jb250cmlidXRv
VybiBBZmZlY3RzIFBy
48ZnVsbC10aXRsZT5B
2RpY2FsPjxwYWdlcz4y
cj48a2V5d29yZHM+
eXdvcmQ+Q0FQSVRB
ybjwva2V5d29yZD48
Q+RUxBU1RJQ0lUWSAo
QVElPTiAoRWNvbm9t
115
ZWFyPjwvZGF0ZXM+
GlzaGVyPjxpc2Ju
2lvbi1udW0+PHdv
Jscz48dXJsPmh0dHA6
lJmFtcDtkYj1idGgm
WJhc2UtbmFtZT48cmVt
GFiYXNlLXByb3ZpZGVy
cj48WWVhcj4xOTgx
VyPjYxPC9yZWMtbnVt
OXQxd3ZwMnJlcnZ4
WYtdHlwZSBuYW1l
PjxhdXRob3JzPjxh
M+PC9jb250cmlidXRv
116
W11bGF0aW9uIGluIGEg
GtleXdvcmQ+Q0FQ
tleXdvcmQ+PGtleXdv
Q+V0FHRVM8L2tleXdv
+PGtleXdvcmQ+RUNP
E8L3llYXI+PC9kYXRl
WJsaXNoZXI+PGlz
NjZXNzaW9uLW51bT48
mxzPjx1cmw+aHR0
WUmYW1wO2RiPWJ0
117
9yZWxhdGVkLXVybHM+
hYmFzZS1uYW1lPjxy
GF0YWJhc2UtcHJvdmlk
0aG9yPjxZZWFyPjE5
mVyPjEwMzwvcmVj
pyZjl0MXd2cDJy
eXM+PHJlZi10eXBl
XRvcnM+PGF1dGhv
V0aG9ycz48L2NvbnRy
RHVyYWJsZSBFeHBl
FyeS10aXRsZT5BbWVy
xlcz48cGVyaW9kaWNh
GwtdGl0bGU+PC9wZXJp
bnVtYmVyPjQ8L251
118
pPC9rZXl3b3JkPjxr
VU1FUiBiZWhhdmlv
2V5d29yZD48a2V5d29y
gZ29vZHMsIENvbnN1
GtleXdvcmQ+QVNT
8eWVhcj4xOTc2PC95
3NvY2lhdGlvbjwvcHVi
k5MjQ8L2FjY2Vz
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B4P2RpcmVjdD10cnVl
9yZW1vdGUtZGF0YWJh
wvcmVtb3RlLWRhdGFi
bGZhc29uPC9BdXRo
119
9yZD48cmVjLW51bWJl
taWQ9Inpmd3py
VpZ24ta2V5cz48
GU+PGNvbnRyaWJ1dG9y
XRob3I+PC9hdXRob3Jz
VTLCBJTkZMQVRJT04s
jb25kYXJ5LXRp
FY29ub21pY3Mg
Z2VzPjIzMzwvcGFn
b3Jkcz48a2V5d29y
4gKEZpbmFuY2UpPC9r
3JkPjxrZXl3b3Jk
kVTVE1FTlRTPC9r
120
3Jkcz48ZGF0ZXM+
zPC9wdWJsaXNoZXI+
wvYWNjZXNzaW9uLW51
C11cmxzPjx1cmw+
XRydWUmYW1wO2Ri
w+PC9yZWxhdGVkLXVy
1kYXRhYmFzZS1uYW1l
UtZGF0YWJhc2UtcHJv
C9BdXRob3I+PFllYXI+
y1udW1iZXI+MTAxPC9y
mZ3enJmOXQxd3Zw
2V5cz48cmVmLXR5
RyaWJ1dG9ycz48YXV0
bnRyaWJ1dG9ycz48
121
3JhbCBTdWJzdGl0dXRp
xkYXRlcz48eWVh
wvQ2l0ZT48Q2l0ZT48
051bT45OTwvUmVj
Z24ta2V5cz48a2V5
yd3JycjAyOTUiPjk5
gQXJ0aWNsZSI+MTc8
3RlaW4sIE1TPC9h
Y29udHJpYnV0b3Jz
gYW5kIHRoZSBwZXJz
RsZT5UaGUgUXVhcnRl
Vjb25vbWljczwvZnVs
2b2x1bWU+ODI8L3Zv
122
hcj48L2RhdGVzPjxp
C9DaXRlPjxDaXRlPjxB
VtPjEwMDwvUmVjTnVt
duLWtleXM+PGtleSBh
ycnIwMjk1Ij4xMDA8
cmVmLXR5cGU+PGNv
G9yPjwvYXV0aG9ycz48
NvbnN1bXB0aW9uPC90
zPjxwdWJsaXNoZXI+
AxOTgyODgyNDc8
0aG9yPkNhcmxpbm88
48cmVjb3JkPjxyZWMt
9IkVOIiBkYi1pZD0i
5PjwvZm9yZWlnbi1r
123
HlwZT48Y29udHJp
dXRob3I+PC9hdXRo
BVEUgRUZGRUNUUyBB
Gl0bGVzPjxwZXJp
m9taWNzPC9mdWxsLXRp
HVtZT45PC92b2x1bWU+
U9OIChFY29ub21p
wva2V5d29yZHM+
MjwvaXNibj48YWNj
GU+QXJ0aWNsZTwvd29y
NoLmVic2NvaG9zdC5j
01MDMwMDU4JmFtcDtz
HJlbW90ZS1kYXRhYmFz
124
ZD48L0NpdGU+PENp
xSZWNOdW0+NTU8L1Jl
aWduLWtleXM+PGtl
yMndycnIwMjk1Ij41
IEFydGljbGUiPjE3
a2luLCBNSjwvYXV0
UYXhhdGlvbiwgc2F2
RhcnktdGl0bGU+VGhl
sZT48L3RpdGxlcz48
b2x1bWU+ODY8L3Zv
cj48L2RhdGVzPjxp
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
kzNjsgUG9vbGUgMTk3
mVzIDIwMDY7IEhlaW0g
Yy1udW1iZXI+PGZv
cmVydnhoNXZyMHA5
5hbWU9IkpvdXJu
cnM+PGF1dGhvcj5Q
XRob3I+PC9hdXRob3Jz
lcmVzdCBSYXRlIG9u
BIeXBvdGhlc2VzOiBF
126
PkFtZXJpY2FuIEVj
jxmdWxsLXRpdGxl
HZvbHVtZT4zNTwv
WFyPjwvZGF0ZXM+
vb2xlPC9BdXRob3I+
48cmVjLW51bWJlcj44
Q9Inpmd3pyZjl0
Z24ta2V5cz48cmVm
GNvbnRyaWJ1dG9ycz48
vY29udHJpYnV0b3Jz
ZCBpbmZsYXRpb24g
XJ5LXRpdGxlPkJyb29r
G9uIEVjb25vbWljIEFj
127
5ZWFyPjE5NzI8L3ll
xzPjwvcmVjb3JkPjwv
L1llYXI+PFJlY051
ZXI+PGZvcmVpZ24t
NXZyMHA5YTIyd3Jy
kJvb2siPjY8L3Jl
pNPC9hdXRob3I+
nZW5lcmFsIHRoZW9y
vdGl0bGVzPjxkYXRl
RpYyBQdWJsaXNoZXJz
MTM8L2lzYm4+PHVy
zwvQXV0aG9yPjxZ
Yy1udW1iZXI+NTA8
128
SJ6Znd6cmY5dDF3
uLWtleXM+PHJlZi10
mlidXRvcnM+PGF1
vY29udHJpYnV0b3Jz
HNlY29uZGFyeS10aXRs
+PHBlcmlvZGljYWw+
ZWNvcmQ+PC9DaXRl
FJlY051bT45Njwv
cmVpZ24ta2V5cz48
A5YTIyd3JycjAyOTUi
WwgQXJ0aWNsZSI+
ltLCBKSjwvYXV0
Db25zdW1lciBEZW1h
129
9yayBTdGF0ZSBFY29u
48cGVyaW9kaWNhbD48
GUgRWNvbm9taWNzIEFz
yPjIwMDQ8L1llYXI+
Yy1udW1iZXI+PGZv
cmVydnhoNXZyMHA5
hbWU9IkpvdXJu
cnM+PGF1dGhvcj5G
cmlidXRvcnM+PHRp
Gxlcz48ZGF0ZXM+PHll
L0NpdGU+PENpdGU+
130
VjTnVtPjU3PC9SZWNO
nbi1rZXlzPjxrZXkg
JyMDI5NSI+NTc8
cmVmLXR5cGU+PGNv
Rob3I+PC9hdXRob3Jz
mIGludGVyZXN0IHJh
GxlPjwvdGl0bGVzPjxk
ZlbG9wbWVudCBFY29u
WNvcmQ+PC9DaXRl
WWVhcj48UmVjTnVt
Jlcj48Zm9yZWlnbi1r
IwcDlhMjJ3cnJy
Sm91cm5hbCBBcnRp
V0aG9yPkF0dGFuYXNp
131
C9hdXRob3I+PC9h
0aW9uIEdyb3d0aCwg
b25kYXJ5LXRpdGxl
PC90aXRsZXM+PHBl
RpZXM8L2Z1bGwtdGl0
A8L3ZvbHVtZT48bnVt
TiAoRWNvbm9taWNz
8a2V5d29yZD5ERU1P
cyk8L2tleXdvcmQ+
SIGdvb2RzPC9rZXl3
B0aGVvcnk8L2tl
hdGVzPjxwdWJsaXNo
c8L2lzYm4+PGFjY2Vz
ydGljbGU8L3dvcmst
132
YnNjb2hvc3QuY29t
W1vdGUtZGF0YWJhc2Ut
Jhc2UtcHJvdmlkZXI+
mQ+PC9DaXRlPjwvRW5k Tm90ZT4A
kzNjsgUG9vbGUgMTk3
mVzIDIwMDY7IEhlaW0g
Yy1udW1iZXI+PGZv
cmVydnhoNXZyMHA5
5hbWU9IkpvdXJu
cnM+PGF1dGhvcj5Q
XRob3I+PC9hdXRob3Jz
133
lcmVzdCBSYXRlIG9u
BIeXBvdGhlc2VzOiBF
PkFtZXJpY2FuIEVj
jxmdWxsLXRpdGxl
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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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148
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dGxlPjxzZWNvbmRhcnktdGl0bGU+Sm91cm5hbCBvZiBNb25leSwgQ3JlZGl0
IGFuZCBCYW5raW5n
PC9zZWNvbmRhcnktdGl0bGU+PC90aXRsZXM+PHBlcmlvZGljYWw+PGZ1b
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PG51bWJlcj44PC9udW1i
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TQ2MTY8L2lzYm4+
PHVybHM+PC91cmxzPjwvcmVjb3JkPjwvQ2l0ZT48Q2l0ZT48QXV0aG9yPkZ
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PjxZZWFyPjE5OTg8L1llYXI+PFJlY051bT4xMDE8L1JlY051bT48cmVjb3JkPj
xyZWMtbnVtYmVy
PjEwMTwvcmVjLW51bWJlcj48Zm9yZWlnbi1rZXlzPjxrZXkgYXBwPSJFTiIgZ
GItaWQ9Inpmd3py
Zjl0MXd2cDJyZXJ2eGg1dnIwcDlhMjJ3cnJyMDI5NSI+MTAxPC9rZXk+PC9m
b3JlaWduLWtleXM+
PHJlZi10eXBlIG5hbWU9IkpvdXJuYWwgQXJ0aWNsZSI+MTc8L3JlZi10eXBl
Pjxjb250cmlidXRv
cnM+PGF1dGhvcnM+PGF1dGhvcj5GZXR6ZXIsIEo8L2F1dGhvcj48L2F1dGh
vcnM+PC9jb250cmli
dXRvcnM+PHRpdGxlcz48dGl0bGU+SW50ZXJlc3QgUmF0ZXMgYW5kIElud
149
GVydGVtcG9yYWwgU3Vi
c3RpdHV0aW9uIGZvciBJbmRpYW4gRmFybSBIb3VzZWhvbGRzPC90aXRs
ZT48L3RpdGxlcz48ZGF0
ZXM+PHllYXI+MTk5ODwveWVhcj48L2RhdGVzPjx1cmxzPjwvdXJscz48L3Jl
Y29yZD48L0NpdGU+
PENpdGU+PEF1dGhvcj5CYWxhc3NhPC9BdXRob3I+PFllYXI+MTk4OTwvW
WVhcj48UmVjTnVtPjU3
PC9SZWNOdW0+PHJlY29yZD48cmVjLW51bWJlcj41NzwvcmVjLW51bWJlcj
48Zm9yZWlnbi1rZXlz
PjxrZXkgYXBwPSJFTiIgZGItaWQ9Inpmd3pyZjl0MXd2cDJyZXJ2eGg1dnIwc
DlhMjJ3cnJyMDI5
NSI+NTc8L2tleT48L2ZvcmVpZ24ta2V5cz48cmVmLXR5cGUgbmFtZT0iQm9
vayI+NjwvcmVmLXR5
cGU+PGNvbnRyaWJ1dG9ycz48YXV0aG9ycz48YXV0aG9yPkJhbGFzc2EsIE
JBPC9hdXRob3I+PC9h
dXRob3JzPjwvY29udHJpYnV0b3JzPjx0aXRsZXM+PHRpdGxlPlRoZSBlZmZl
Y3RzIG9mIGludGVy
ZXN0IHJhdGVzIG9uIHNhdmluZ3MgaW4gZGV2ZWxvcGluZyBjb3VudHJpZX
M8L3RpdGxlPjwvdGl0
bGVzPjxkYXRlcz48eWVhcj4xOTg5PC95ZWFyPjwvZGF0ZXM+PHB1Ymxpc
2hlcj5EZXZlbG9wbWVu
dCBFY29ub21pY3MsIFdvcmxkIEJhbms8L3B1Ymxpc2hlcj48dXJscz48L3Vyb
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
150
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

153
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

158
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
160
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.

164
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
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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

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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
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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.
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
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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
176
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.
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
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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.
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The Effect of Change in Interest Rate On Consumption and GDP in UK

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1

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

2.2 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

consumption and saving behaviour of the individuals through different policies

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

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.

interest rate influences the consumption and saving in several ways.

Moreover, government uses interest rate as a monetary tool.