Discussion Paper No. 1389 examines the impact on consumption of cyclical (credit crunches) and structural (financial liberalization) changes in credit supply. Using UK data, Research Affiliate Andrew Scott finds that a large number of individuals borrow, that they hold different types of debt and that the borrowing rate varies across different forms of debt. This gives the consumer the opportunity to borrow more, but at increasing interest rates. Focusing on the consumer's optimization problem, if Scott finds that aggregate consumption growth depends on the (upward sloping) interest rate, the wedge between borrowing and lending rates, and on debt/income ratios. This formulation has the potential to explain previous rejections of the rational expectations permanent income hypothesis, to rationalize the predictive role for the borrowing wedge, and to explain the importance of credit in driving consumption fluctuations.

For even moderate levels of risk aversion, the threat of having to pay high borrowing rates means that consumers rarely borrow. Instead, they accumulate precautionary balances to avoid having to pay penal interest rates in bad states of the world. As a result, consumers hold very little non-secured debt. Owing to the upward-sloping interest rate schedule, individual consumption is tied even more closely to individual income than where imperfect capital markets manifest solely as constraints imposed by borrowers. Scott considers the impact of financial deregulation and cyclical variation in loan supply within a general equilibrium framework. His analysis suggests that structural changes in the supply of credit have only a modest impact on consumption because consumers tend to hold very little debt.

Consumption, 'Credit Crunches' and Financial Deregulation
Andrew Scott