Financial Integration and Consumption Smoothing

We present a new empirical strategy for testing if financial integration improves risk sharing opportunities and consumption smoothing. Our test is based on a decomposition of the variance of consumption growth into a component that depends on the variance of permanent income shocks and one that depends on the variance of transitory shocks. We then test if the process of financial market integration and liberalization brought about by the introduction of the euro has made consumption less sensitive to income shocks in Italy. The paper makes a significant contribution also from a methodological point of view. We use panel data on income to identify non parametrically a time series of the variances of the income shocks. We then rely on repeated cross-sections of consumption and income to identify the degree of smoothing with respect to income shocks, and test if it has declined after the introduction of the euro. Our procedure does not require that consumption and income are available in the same panel data. It can therefore be applied in all countries in which repeated cross-sectional consumption data can be combined with panel data on income.