Working Paper: CEPR ID: DP1389
Authors: Andrew Scott
Abstract: We examine whether credit contributes to business cycle fluctuations by directly affecting consumption rather than through the now well-understood investment channel. Examining UK data we argue that consumers face a rising interest rate schedule whereby additional borrowing leads to higher interest rates. At a certain level of debt this schedule may become vertical and consumers face a credit ceiling. Using this assumption we find consumption growth depends on the interest rate, the borrowing wedge, and the debt-income ratio, and that we can potentially account for the failings of the rational expectations permanent income hypothesis (REPIH). Risk aversion and the interest rate schedule interact such that agents choose not to hold much debt, however, and so consumers are not much affected by ?credit crunches?, although the more efficient the capital market, the bigger the impact. Calibrating our model and performing simulations suggests the sharp increases in UK consumption in the late 1980s were more likely due to income revisions than financial deregulation per se.
Keywords: consumption; credit constraints; credit crunch; financial deregulation; precautionary saving
JEL Codes: E2; E3; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| upward sloping interest rate schedule (E43) | borrowing wedge (G51) |
| borrowing wedge (G51) | debt-to-income ratio (G51) |
| debt-to-income ratio (G51) | consumption growth (E20) |
| upward sloping interest rate schedule (E43) | consumption growth (E20) |
| credit crunches (E51) | consumption growth (E20) |
| efficiency of capital markets (G14) | impact of credit crunches on consumption (E21) |
| income expectations (J31) | consumption surge (E21) |