Loss Aversion, Economic Sentiments and International Consumption Smoothing

61 Pages Posted: 24 Apr 2019

See all articles by Daragh Clancy

Daragh Clancy

European Stability Mechanism

Lorenzo Ricci

European Stability Mechanism; Université Libre de Bruxelles (ULB)

Date Written: April 9, 2019

Abstract

We examine an unexplored connection between loss aversion and international consumption smoothing. In the face of expected income declines, loss-averse behaviour implies that any adjustments in consumption are delayed until they are necessary. However, if the expected fall in income materialises, the eventual adjustments in consumption are larger. Therefore, loss aversion could weaken international consumption smoothing. We test this mechanism using measures of economic sentiment. These provide a sense of the expected direction of future income changes. We demonstrate that prevailing confidence and uncertainty, our proxies for economic sentiment, reduce the degree of international consumption smoothing. We provide evidence that this effect arises from loss-averse behaviour, using a test of the asymmetric response of consumption to positive and negative output fluctuations that occur following periods of weak economic sentiment. Our findings have important implications for public institutions and private initiatives that aim to improve cross-country risk sharing.

Keywords: onfidence, consumption smoothing, loss aversion, uncertainty

JEL Classification: E21, E71, F41, F44

Suggested Citation

Clancy, Daragh and Ricci, Lorenzo, Loss Aversion, Economic Sentiments and International Consumption Smoothing (April 9, 2019). European Stability Mechanism Working Paper No. 35 (2019). Available at SSRN: https://ssrn.com/abstract=3376470 or http://dx.doi.org/10.2139/ssrn.3376470

Daragh Clancy (Contact Author)

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Lorenzo Ricci

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Université Libre de Bruxelles (ULB) ( email )

Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
Belgium

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