Consumption, 'Credit Crunches' and Financial Deregulation

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 constraint, credit crunch, financial deregulation, precautionary saving

JEL Classification: E2, E3, E5