Consumption and credit: a model of time-varying liquidity constraints

This paper investigates the role of consumer credit in determining real consumption growth in aggregate, post-war U.S. data. This paper presents evidence that predictable growth in consumer credit is significantly related to consumption growth. The finding is inconsistent with the predictions of (I) the permanent income/life cycle hypothesis, (ii) the "rule of thumb" models where some agents simply consume their current income, and (iii) models of liquidity constraints where individuals face a fixed borrowing limit. I argue that this finding calls for reinterpretation of the excess sensitivity of consumption to current resources and suggests a model of liquidity constraints in which the borrowing limitation is time-varying and dependent on current income. The theoretical framework rationalizes the importance of predictable credit growth in determining consumption growth. The model can also be employed to stimulate the real effects of a one-time deregulation, or "evolution" in household credit markets. This exercise indicates that the (constraint induced) dependence of consumption on current resources may not be permanently eliminated when moderate amounts of additional credit are made available. Furthermore, the expansion generates a short term boom in consumption.