Consumption convergence: theory and evidence

Abstract

This study aims to construct a sound theory of consumption convergence and empirically test its viability. To do this, we employ a Solovian framework in which the Keynesian exogenous savings-consumption allocation rule plays a crucial role. We demonstrate that consumption convergence performance is determined by both the average propensity to save (the indirect effect) and the average propensity to consume (the direct effect). In the empirical section, we use a system GMM estimator to test our consumption convergence equation on a panel data set of 177 countries and four income groups from 1970 to 2019. Our empirical findings indicate (i) absolute consumption convergence within high- and low-income country groups; (ii) strong evidence of conditional consumption convergence within high-, upper-middle-, and lower-middle-income groups; (iii) a robust and significant effect of the average propensity to save on the convergence process in high-, upper-middle-, and lower-middle-income groups; and (iv) a more robust and significant effect of the average propensity to consume in upper-middle- and lower-middle-income countries. In summary, we find that as income rises, the indirect impact plays a larger role in explaining consumption convergence, whereas the direct effect plays a smaller role. The policy implication of this conclusion is that policy makers in upper-middle- and lower-middle-income countries should restore the balance in the tradeoff between current and future consumption in favor of savings, as the former will harm consumption convergence within each middle-income group.