DP16634 Financial Innovation, the Decline in Household Savings, and the Trade-off between Flexibility and Commitment
This paper investigates the trade-off between two opposing views of financial innovation: the benefit of improved flexibility and the potential cost of weakened commitment. To disentangle their relative importance, we estimate a model of household behavior
that allows for the possibility that housing acts as a savings commitment device. Identification is achieved using novel evidence on consumption growth dynamics. We then use the estimated model to study the macroeconomic and welfare implications
of giving households greater access to home equity. We find that the welfare cost of weakened commitment is substantial: approximately 1.7 times larger than the benefit of improved consumption smoothing. Both channels contribute equally to a 2.5 percentage
point decline in the personal saving rate. Welfare could be improved using alternative mortgage policies that better balance the trade-off between flexibility and commitment.
