FINANCIAL INTEGRATION AND CONSUMPTION SMOOTHING*

We test if financial integration improves household consumption smoothing using microeconomic data. We find that the process of financial market integration and liberalisation brought about by the introduction of the euro has not affected the sensitivity of consumption with respect to income shocks in Italy. This article also makes a significant contribution from a methodological point of view, because our procedure does not require that consumption and income are available in the same panel data set. It can therefore be applied in all countries in which repeated cross-sectional con-sumption data can be combined with panel data on income. The European Monetary Union (EMU) has removed exchange rate risk and lowered cross-border transaction costs, opening the possibility for the creation of a fully inte-grated continental financial market comparable with that of the US. To what extent has this process of regulatory reform affected the ability of households to diversify, insure and shoulder risks? This article attempts to answer this question, which is at the heart of the burgeoning literature on the links between regulation, finance and real economic activity. To answer the question, we study the effect of the euro policy shift with Italian household-level income and consumption data spanning two decades (1987–2006)