Consumption Smoothing in the Least Developed Countries

A key ingredient to modern economic theory is the assumption that individuals smooth their consumption over time. I explore this hypothesis in panel of 47 Least Developed Countries (LDC) over the period 1950-2000, using rainfall as an instrumental variable to generate exogenous, transitory variation in annual per capita GDP. Instrumental variable estimates yield that a 1% increase in income per capita due to rainfall shocks led to an average increase in consumption by around 0.9%. While IV estimates are significantly different from 0 at over 99.9 confidence, one can not reject the hypothesis that they are significantly different from 1. Hence, there is virtually no evidence of consumption smoothing at the macroeconomic level in the Least Developed Countries. Not only does this put to serious question the permanent income hypothesis, which has been a cornerstone of modern macroeconomic theory, it may also help explain the poor growth performance of LDC countries.