DP12270 Household Debt and Monetary Policy: Revealing the Cash-Flow Channel
We examine the effect of monetary policy on household spending when households are indebted and interest rates on outstanding loans are linked to short-term interest rates. Using administrative data on balance sheets and consumption expenditure of Swedish households, we reveal the cash-flow transmission channel of monetary policy. On average, indebted households reduce consumption spending by an additional 0.25-0.35 percentage points in response to a one-percentage-point increase in the policy rate, relative to a household with no debt. This is true among households with low or high levels of illiquid wealth, such as homeowners, who hold disproportionally little liquid wealth and display hand-to-mouth behavior when faced with increased interest expenses. We show that these responses are driven by households that have some or a large share of their debt in contracts where interest rates vary with short-term interest rates, such as adjustable-rate mortgages (ARMs), which implies that monetary policy shocks are quickly passed through to interest expenses.