of income shocks may lower the volatility of consumption as agents would be less likely to adjust their consumption in response to such shocks. If the persistence of the income shocks decreases around the time when the elasticity of consumption to income declines, the results could then be attributed to agents’optimal response to this drop in the persistence, and not necessarily to an increase in the degree of financial integration.

To check the role of the persistence of the income shocks, we analyze how the persistence of income shocks evolves over time using Total Factor Productivity (TFP) data from PWT 8.1. Specifically, we study the evolution of the median AR(1) coeffi cient of the changes in TFP for each country group. For the full sample, as well as for the advanced and developing country sub-groups, the median persistence has increased slightly until the late 1980s (from near zero in the late 1970s to close to 0.2 in late 1980s, but has not changed much since then). This would suggest that the decline in the sensitivity of consumption to income changes could not have been associated with the changes in the persistence of income shocks (Figure A1 in the Appendix).

The sensitivity of consumption to income can also be affected by the correlation between the permanent and transitory components of expected shocks to income (Deaton, 1987; Quah, 1991). The sensitivity of consumption to income would be lower if the correlation between the permanent and transitory shocks is negative. A decomposition of permanent and transitory components would require detailed information on expected income but it is not possible with the aggregate data we have here. However, this remains an interesting avenue for future research.

Changes in the correlation of income shocks: The elasticity of consumption to income also depends on the cross-country correlations of income shocks. On the one hand, if income shocks are highly correlated, this would lower incentives to share risk ex-ante with the rest of the world and may increase the sensitivity of consumption to domestic income. On the other hand, if highly correlated cross-country income shocks are due to a decline in global uncertainty, this can facilitate cross-border borrowing and lending, and, in turn, lead to a lower sensitivity of consumption to income. We analyze the evolution of the cross-country correlation of TFP shocks. Our findings indicate that the average cross-country TFP correlations have been essentially flat for most of the period (Figure A2 in the Appendix). Given the absence of a trend in the evolution of TFP correlations, it is unlikely that the sensitivity of consumption to income has declined because of changes in these correlations.

Convergence of interest rates: The sensitivity of consumption to income can be lower because of the convergence of interest rates over time. In an economy with participation constraints, only some agents can borrow and lend at the world interest rate, which tends to be lower than the domestic interest rate. As the economy becomes more financially integrated, more agents are able to access international financial markets and undertake transactions at the world interest rate. As the degree of financial integration increases globally, national interest rates tend to converge to the world rate, making countries subject to similar interest rate shocks. Assuming the world interest rate is less volatile than national interest rates, this would imply lower volatility of consumption growth and higher cross-country correlations of consumption. A lower interest rate and less volatile consumption growth would decrease savings and increase borrowing at the margin. As a result, the degree of co-movement of consumption with domestic income would decrease, making it harder to disentangle the impact of interest rates from that of financial integration on the sensitivity of consumption to income in a regression framework like the one we presented earlier.

However, observed interest rates might not fully reflect the degree of financial integration of an economy as they are affected by many other factors, including country risk premia, and monetary 11