THE WORLD BANK ECONOMIC REVIEW, VOL. 14, NO. 3: 457-80 What Drives Consumption Booms? Peter J. Montiel Consumption booms have been common in both industrial and developing countries, and several explanations have been offered for their occurrence. These include economy- wide wealth effects associated with favorable movements in the terms of trade or eu- phoric expectations triggered by macroeconomic reforms, Ricardian effects associated with fiscal stabilization, lending booms following financial liberalization, and a variety of distortions m mtertemporal relative prices. Using a large cross-country sample of booms, this article assesses how widely applicable these explanations are. The key find- ing is that wealth effects linked to favorable movements in the terms of trade and antici- pated improvements in macroeconomic performance seem to have been more important empirically than explanations relying primarily on fiscal phenomena or distortions in intertemporal relative prices. Consumption booms, common in both industrial and developing countries, have been associated with a variety of macroeconomic events, including stabilization of high inflation, surges in capital inflows, the implementation of market- oriented structural reforms (especially trade and financial liberalization), and fa- vorable movements in the external terms of trade. They are often perceived as policy problems because of their effects on demand for home goods, the trade balance, and the resources available for investment. The emergence of a con- sumption boom may, for example, undermine the objective of stabilizing infla- tion by putting upward pressure on the prices of home goods. Similarly, a con- sumption boom that arises during an episode of capital inflows may significantly increase the country's current account deficit, which may, in turn, undermine the credibility of the prevailing exchange rate and contribute to capital flow rever- sals. The recent example of Mexico has now become notorious, but similar, if relatively muted, booms have characterized several other capital-importing coun- tries in Latin America. Despite the occasional attention given to specific episodes, researchers have only recently begun to study the causes of consumption booms in a systematic way. By and large, their analysis has been confined to speculation based on ca- sual empiricism in descriptive studies focusing on other issues (such as stabiliza- tion episodes and surges in capital inflows). 1 In these contexts several competing 1. Exceptions include Rebelo and Vegh (1996) and Reinhart and Vegh (1995). Peter J. Montiel is professor in the Department of Economics at Williams College. His e-mail address is pmontiet@wiUiams.edu. The author gratefully acknowledges comments on earlier drafts from Barry Bosworth, Carlos Vegh, and two anonymous referees. © 2000 The International Bank for Reconstruction and Development/THE WORLD BANK 457 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized