to income and its temporal evolution. Section 4 analyzes the linkages between financial integration and the sensitivity of consumption to income, and undertakes a battery of robustness tests. Section 5 provides a discussion of alternative explanations. Section 6 offers some concluding remarks.

# 2 Database and Econometric Framework

## 2.1 Database

We examine the evolution of the sensitivity of consumption to income changes using a rich database that includes 88 countries, including 22 advanced and 66 developing economies, over the period 1960-2011 for our baseline specification. The database includes time-series of income, consumption, measures of financial integration, world and country specific interest rates, and variables capturing various country-specific features.<sup>6</sup> The data series for income and consumption are from the Penn World Tables (PWT 8.1). Per capita real income and per capita consumption correspond to the measures of national output and private consumption, respectively. It is widely known that aggregate output and consumption data are nonstationary, whereas first differences of these variables are not. We employ a wide range of panel unit root tests to check the statistical features of output and consumption series in our database. The results indicate that the (log) level of income and consumption series are nonstationary, but their first (log) differences are stationary.<sup>7</sup> Hence, we follow the previous literature and carry out the analysis using first differenced series.

An ideal dataset to evaluate the impact of financial integration on the sensitivity of consumption to income changes should include direct measures of the effectiveness of restrictions on the capital account. Unfortunately, the available measures of restrictions on the capital account are much cruder for the broad set of countries in our sample. To maximize the information from available datasets, we use an array of rule-based (de jure) measures of financial integration. We also check the robustness of our findings by controlling for outcome-based (de facto) measures.

Our database includes multiple de jure measures of financial integration that are based on the information drawn from the International Monetary Fund’s Exchange Restrictions and Exchange Arrangements (AREAER). The data series are mainly coded as a series of binary variables capturing whether a country has any restriction on its external (current and financial) accounts. A zero (0) indicates that there are restrictions in place and a one (1) suggests that the country is fully liberalized. The data distinguish between the existence of multiple exchange rate practices, restrictions on the capital account, the current account or the ability to repatriate proceeds from exports. The original data do not distinguish between restrictions on inflows and outflows, and are available for the period 1966-2011.

We focus on two de jure measures of financial integration for our baseline results. Our first measure, based on the work by Chinn and Ito (2006), tracks the first standardized principle component of the major categories in the AREAER tables, including current account restrictions,

> 6 The sample length is dictated by data availability. Most measures of financial integration are available only up to 2011: (i) IMF AREAER indicators are available for the 1966-2011 period; (ii) Quinn openness indicator is available for 1940-2011; (iii) Data series from Lane and Milesi-Ferretti and Chinn-Ito are available for the 1970-2011 period.

> 7 We employ the tests offered by Levin, Lin and Chu (2002), Im, Pesaran and Shin (2003), and Hadri (2000). They all point to the same conclusions. The results of these tests are available upon request.

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