Consumption Velocity in a Cash Costly-Credit Model

In a seminal study Hodrick et al. (1991) evaluate the ability of a simple cash-credit model to produce realistic variability in consumption velocity while at the same time successfully explaining other key statistics. Sufficient variability in the latter is found to be associated with far too volatile interest rate behaviour. Introducing habit-formation in consumption into a production-based cash costly-credit model (see Gillman and Benk, 2007) makes the evolution of deposits more rigid relative to credit. The same deposit rigidity leads to a more volatile price of credit, causing credit production overshooting relative to deposits. But only by introducing adjustment costs to investment in addition to habit persistence does credit production overshoot sufficiently to produce realistic variability in consumption velocity. The model succeeds in capturing sufficient variability in consumption velocity without obtaining too volatile interest rates. Also, this model of endogenous velocity does not suffer from indeterminacy problems discussed in Auray et al. (2005). In contrast to Gillmand and Benk (2007), the present study examies the role of the price-channel of credit production at business cycle frequency, ignoring or holding fixed the marginal cost channel stemming from credit productivity shocks.