Exchange rate volatility and domestic consumption: Evidence from Japan

In 1952, Alexander provided an argument that since inflationary effects of depreciation could shift income from workers to producers it could lead to a decline in aggregate domestic consumption. This was based on the assumption that wages do not adjust fully to inflation and labor has a high MPC relative to that of the producers. In this paper, we argue that in addition to the exchange rate itself, exchange rate uncertainty could also affect domestic consumption. We demonstrate our conjecture by using quarterly data from Japan and a bounds testing approach that distinguishes the short run from the long run.

► For the first time in the literature, we introduce exchange rate volatility into the consumption function. ► We estimate the proposed consumption function for Japan. ► We use a GARCH-based measure of exchange rate volatility. ► We distinguish short-run effects from long-run effects.