Debt and the Consumption Response to Household Income Shocks

Abstract

This paper exploits a detailed new dataset with comprehensive panel financial information on millions of American households to investigate the interaction between household balance sheets, income, and consumption during the Great Recession. In particular, I test whether consumption among households with higher levels of debt is more sensitive to a given change in income. I match households to their employers and use shocks to these employers to derive persistent and unanticipated changes in household income. I find that highly-indebted households are more sensitive to these income fluctuations and that a one standard deviation increase in debt-to-asset ratios increases the elasticity of consumption by approximately 25%. I employ direct measures of asset levels, available credit, and potential credit access to show that these results are driven almost entirely by borrowing and liquidity constraints. These estimates suggest that the drop in consumption during the 2007-2009 recession was approximately 20% greater than what would have been seen with the household balance sheet positions seen during the 1980s.

Keywords: debt, balance sheets, heterogeneous households, income shock, firm shock, consumption elasticity

JEL Classification: D10, E21, E24