Microfoundations - Consumption PDF

ECO3002: Advanced Macroeconomics Topic: Microfoundations - Consumption Microfoundations ECO3002: Advanced Macroeconomics 1 / 67 This lecture covers Theory of consumer behaviour I What is household consumption? I Keynesian theory of consumption I Neoclassi...

ECO3002: Advanced Macroeconomics Topic: Microfoundations - Consumption Microfoundations ECO3002: Advanced Macroeconomics 1 / 67 This lecture covers Theory of consumer behaviour I What is household consumption? I Keynesian theory of consumption I Neoclassical consumption model I The permanent-income hypothesis I Consumption as a random walk I The life-cycle model of consumption Case study: household debt since the Global Financial Crisis Microfoundations ECO3002: Advanced Macroeconomics 2 / 67 Theory of consumer behaviour Microfoundations ECO3002: Advanced Macroeconomics 3 / 67 Components of GDP The national income identity is given by: Y = C + I + G + NX where: Y = GDP C = Consumption I = Investment G = Government purchases NX = Net exports = Exports − Imports Goods and services can be consumed, invested by private sector, bought by the government or shipped abroad for foreign users to use. Microfoundations ECO3002: Advanced Macroeconomics 4 / 67 Consumption definition: OECD National Accounts Household final consumption expenditure covers all purchases made by resident households (home or abroad) to meet their everyday needs: food, clothing, housing services (rents), energy, transport, durable goods (cars), spending on health, on leisure and on miscellaneous services. It also includes a number of imputed expenditures (for example, agricultural products produced for own-consumption). Partial payments for goods and services provided by general government are included in household final consumption. This covers cases in which households have to pay a part of the public services provided, for example prescription medicines and medical services partly reimbursed by government. Microfoundations ECO3002: Advanced Macroeconomics 5 / 67 Total household spending (% of GDP): G7 countries Source: OECD (2024), household spending (indicator). Microfoundations ECO3002: Advanced Macroeconomics 6 / 67 Keynesian consumption theory What key economic forces shape consumer’s decisions? We begin our study of consumption with J. M. Keynes and his General Theory which was published in 1936. Keynes made conjectures about the consumption function that were based on introspection and casual observation: 1 The marginal propensity to consume (the amount consumed out of an additional dollar of income) is between zero and one. 2 The ratio of consumption to income, called the average propensity to consume falls as income rises. 3 Income is the primary determinant of consumption and interest rate does not have an important role. Microfoundations ECO3002: Advanced Macroeconomics 7 / 67 Keynesian consumption theory (cont.) On the basis of these three conjectures, the Keynesian consumption function is often written as: c = c̄ + βy (1) where: c̄ > 0, 0 < β < 1 In equation (1), c is consumption, y is disposable income, c̄ is a constant and β is the marginal propensity to consume. Microfoundations ECO3002: Advanced Macroeconomics 8 / 67 Keynesian consumption theory (cont.) This function exhibits the three properties that Keynes posited. 1 First property: the marginal propensity to consume is between 0 and 1. 2 Second property: c c̄ + βy c̄ APC = = = +β y y y c̄ c as y rises, y falls and thus y falls. 3 Third property: the interest rate is not included in this equation as determinant of consumption. Microfoundations ECO3002: Advanced Macroeconomics 9 / 67 The Keynesian consumption function MPC is the slope of the consumption function, whereas APC is the slope of a line drawn from the origin to a point on the consumption function. Microfoundations ECO3002: Advanced Macroeconomics 10 / 67 Consumption puzzle The earliest studies indicated that the Keynesian consumption function was a good approximation of how consumers behave. In these studies, researchers surveyed households and collected data on consumption and income. However, two anomalies soon arose: (i) secular stagnation, and (ii) findings by S. Kuznets. First anomaly: secular stagnation. On the basis of the Keynesian consumption function, as incomes in the economy grow over time, households would consume a smaller and smaller fraction of their incomes → the low consumption would lead to an inadequate demand for goods and services resulting in a long depression of indefinite duration. In reality, the conjecture of Keynes that the average propensity to consume would fall as income rose appeared not to hold. Microfoundations ECO3002: Advanced Macroeconomics 11 / 67 Consumption puzzle (cont.) Second anomaly: findings by S. Kuznets. He constructed new aggregate data on consumption and income back to 1869. He found that the ratio of consumption to income was remarkably stable from decade to decade, despite the large increases in income over the period he studied. Again, the conjecture of Keynes that the average propensity to consume would fall as income rose appeared not to hold. These facts presented a puzzle → economists wanted to know why some studies confirmed the conjectures of Keynes and others refuted them. The evidence suggested that there were two consumption functions: I For the household data and the short time-series, the Keynesian consumption function appeared to work well. I For long time-series, the consumption function appeared to exhibit a constant average propensity to consume. Microfoundations ECO3002: Advanced Macroeconomics 12 / 67 Consumption puzzle (cont.) Microfoundations ECO3002: Advanced Macroeconomics 13 / 67 The neoclassical consumption model Now, we analyse the neoclassical consumption model developed by I. Fisher in the first half of the twentieth century. This model is a building bloc of modern macroeconomics. Starting point: people may earn income today and in the future, they consume today and in the future, and a key decision they have to make is how much to consume today versus how much to consume in the future. This model is based on two main elements: 1 intertemporal budget constraint; 2 utility function. Microfoundations ECO3002: Advanced Macroeconomics 14 / 67 Intertemporal budget constraint Assume that as of this moment a consumer has financial wealth equal to ftoday. This financial wealth includes the agent’s savings account balance and all their holdings of stocks and bonds. The agent earns labour income today, ytoday , and in the future, yfuture. Letting c and R denote consumption and interest rate, respectively, the agent faces the following two budget constraints: ctoday + (ffuture − ftoday ) = ytoday (2) cfuture = yfuture + (1 + R)ffuture (3) Microfoundations ECO3002: Advanced Macroeconomics 15 / 67 Intertemporal budget constraint (cont.) Both the equations have the form consumption plus savings equals income. ctoday + (ffuture − ftoday ) = ytoday cfuture = yfuture + (1 + R)ffuture Equation (2) applies to today and ffuture − ftoday represents the amount that the agent sets aside to increase the balance in her financial account. Equation (3) applies to the future where she earns labour income yfuture but also earns interest for her financial wealth. Because this is the last period of life, there is nothing to save for, and she consumes all of her income and wealth at that point. Combining (2) and (3) yields the agent’s intertemporal budget constraint. Solving equation (3) by ffuture gives: cfuture − yfuture ffuture = 1+R Microfoundations ECO3002: Advanced Macroeconomics 16 / 67 Intertemporal budget constraint (cont.) Substituting the last expression in equation (2) and rearranging gives: cfuture − yfuture ctoday + − ftoday = ytoday ⇒ 1+R cfuture yfuture ctoday + = ftoday + ytoday + (4) | {z 1 + R} | {z } financial wealth | {z 1 + R} present value of consumption human wealth Equation (4) says that the present discounted value of consumption must be equal to total wealth. The agent consumption is constrained by the total resources that will be available to her in the present and in the future. These resources include her existing financial wealth ftoday but they also include her human wealth, the present discounted value of labour income. Microfoundations ECO3002: Advanced Macroeconomics 17 / 67 Utility We assume that the agent chooses her consumption today and in the future in order to maximize her utility. If the agent consumes some amount c in a given period, we assume that she receives u(c) units of utility. We also assume that the agent gets more utility whenever her consumption is higher, but that consumption runs in diminishing returns → consumption exhibits diminishing marginal utility. Diminishing marginal utility is reflected in the curvature of the utility function, which gets flatter and flatter as consumption increases. Microfoundations ECO3002: Advanced Macroeconomics 18 / 67 Utility function Each additional unit of consumption raises utility by a smaller and a smaller amount. Microfoundations ECO3002: Advanced Macroeconomics 19 / 67 Lifetime utility function Because the agent consumes in two periods, utility depends on consumption today and consumption in the future. Lifetime utility function: U = u(ctoday ) + βu(cfuture ) (5) The parameter β is called discount parameter and captures the weight that the agent places on the future, relative to today. If β = 1 then the agent treats the utility received today and in the future equally. Normally β < 1, this means that a given flow of utility is more worth when it occurs today. Microfoundations ECO3002: Advanced Macroeconomics 20 / 67 Maximization problem The agent gets the utility from consuming in each period, as in equation (5), and she must choose her consumption to satisfy the intertemporal budget constraint in equation (4): max U = u (ctoday ) + βu (cfuture ) {ctoday ,cfuture } cfuture s.t. : ctoday + = X̄ (6) 1+R where total wealth is denoted by X̄ : yfuture X̄ = ftoday + ytoday + (7) 1+R Microfoundations ECO3002: Advanced Macroeconomics 21 / 67 Maximization problem (cont.) We can solve this problem as follows. In the intertemporal budget constraint (6) we can solve by cfuture : cfuture
ctoday + = X̄ ⇒ cfuture = (1 + R) X̄ − ctoday 1+R Substituting the last expression in the utility function we can rewrite the problem as: 
 max U = u (ctoday ) + βu (1 + R) X̄ − ctoday {ctoday } We solve by setting the derivative of utility with respect to ctoday equal to zero: u 0 (ctoday ) − βu 0 (cfuture ) (1 + R) = 0 Microfoundations ECO3002: Advanced Macroeconomics 22 / 67 Euler equation Rearranging the last expression we obtain: u 0 (ctoday ) = β(1 + R)u 0 (cfuture ) (8) Equation (8) is called the Euler equation for consumption. This equation lies at the heart of advanced macroeconomic models. Intuition: the economic agent must be indifferent between consuming one more unit today on the one hand and saving that unit and consuming it in the future on the other. I If the agent consumes today, she gets the marginal utility of consumption today, u 0 (ctoday ). I If the agent saves that unit instead, she gets to consume 1 + R units in the future, each giving her u 0 (cfuture ) extra units of utility. Because this utility comes in the future, it must be discounted by the weight β. Microfoundations ECO3002: Advanced Macroeconomics 23 / 67 Solving the Euler equation: log utility Let’s assume a logarithmic utility function: u(c) = log c The marginal utility of consumption is: 1 u 0 (c) = c Therefore, the Euler equation (8) can be rewritten as: 1 1 = β(1 + R) ctoday cfuture Rearranging the last equation we obtain that: cfuture = β(1 + R) (9) ctoday Microfoundations ECO3002: Advanced Macroeconomics 24 / 67 Solving the Euler equation: log utility (cont.) Let’s focus on each element of the Euler equation: cfuture = β(1 + R) ctoday This equation says that the agent chooses her consumption so that the growth rate of consumption is the product of the discount parameter and the interest rate that she can earn on her savings. If the agent is very impatient, she places less weight on future utility (a lower β), and consumption growth is lower. In contrast, a higher interest rate raises the return to saving, and consumption growth is higher. The Euler equation explains how interest rates and consumption growth rates are linked. Microfoundations ECO3002: Advanced Macroeconomics 25 / 67 Solving for ctoday and cfuture : log utility and β = 1 The Euler equation (9) has two unknowns, ctoday and cfuture. Therefore to solve for consumption today and in the future, we need one more equation. As second equation, we use the intertemporal budget constraint (6). Therefore, the system of equations is given by: cfuture = β(1 + R) ctoday cfuture ctoday + = X̄ 1+R Now consider the case of β = 1. Microfoundations ECO3002: Advanced Macroeconomics 26 / 67 Solving for ctoday and cfuture : log utility and β = 1 (cont.) From the Euler equation we have: cfuture cfuture = β(1 + R) ⇒ = ctoday ctoday (1 + R) Plugging this result into the intertemporal budget constraint implies: cfuture ctoday + = X̄ ⇒ ctoday + ctoday = X̄ ⇒ 1+R 1 ctoday = X̄ (10) 2 and: cfuture cfuture cfuture ctoday + = X̄ ⇒ + = X̄ ⇒ 1+R (1 + R) (1 + R) 1 cfuture = (1 + R) X̄ (11) 2 Microfoundations ECO3002: Advanced Macroeconomics 27 / 67 The effect of a rise in R on consumption How does consumption respond to a rise in the interest rate? Wealth effect. I From equation (7), recall that total wealth depends on the interest rate because it includes the present discounted value of labour income. I A higher interest rate will reduce this present value: yfuture X̄ = ftoday + ytoday + 1+R I from equation (10), this implies a reduction in consumption in the case of log utility: 1 ctoday = X̄ 2 I Wealth effect because it works through the total wealth term. Microfoundations ECO3002: Advanced Macroeconomics 28 / 67 The effect of a rise in R on consumption (cont.) Substitution effect and income effect. I In the case of the log utility, these effects offset each other → this is why the interest rate does not appear explicitly in equation (10). I However, when the utility takes a different form these effects enter. I The substitution effect of a higher interest rate is that current consumption is now more expensive (because saving will lead to even more consumption in the future), so consumers will tend to reduce their consumption today and increase it tomorrow. I The income effect means that the consumers are now richer (because their current saving leads to more income in the future), which makes them want to consume more today and tomorrow. I Because both effects increase the amount of future consumption, we can conclude that an increase in the real interest rate raises future consumption. However, these two effects have opposite impacts on current consumption, so the increase in the interest rate could either lower or raise it. Microfoundations ECO3002: Advanced Macroeconomics 29 / 67 The permanent-income hypothesis (PIH) This theory was developed by M. Friedman in 1957. From equation (10), we saw that consumption is proportional to the consumer’s overall wealth: 1 ctoday = X̄ 2 However, from equation (7), we know that overall wealth depends on the present discounted value of income: yfuture X̄ = ftoday + ytoday + 1+R Thus, consumption depends on the present discounted value of income → the PIH is one implication of the neoclassical consumption model. Microfoundations ECO3002: Advanced Macroeconomics 30 / 67 Consumption smoothing The intuition behind the permanent-income result is that consumers wish to smooth their consumption over time. Assume that β = 1 and R = 0. Assume that the agent could consume c1 today and c2 in the future or could consume the average of these two values in both periods. Because of diminishing marginal utility, the agent prefers to smooth consumption and take the average in both periods. Microfoundations ECO3002: Advanced Macroeconomics 31 / 67 Consumption smoothing (cont.) Lifetime utility is higher when the agent gets u(c̄) in both periods rather than u(c1 ) + u(c2 ). Microfoundations ECO3002: Advanced Macroeconomics 32 / 67 Consumption smoothing (cont.) What happens if R > 0? From the Euler equation, we know that this change leads consumption to grow over time. Because of the agent’s desire to smooth consumption, she must be paid a positive interest rate not to keep consumption constant. Microfoundations ECO3002: Advanced Macroeconomics 33 / 67 The Ricardian equivalence The impact of fiscal policy on the economy depends crucially on one important consideration. The government faces a budget constraint: if it decides to increase spending today, then either it must reduce spending in the future or it must raise taxes at some point to pay for the higher spending. It is subject to what is often called the no-free-lunch principle: higher spending today must be paid for, if not today at some point in the future. The essence of the Ricardian approach to the government is that consumption depends on the present discounted value of taxes and is invariant to the timing of taxes. Microfoundations ECO3002: Advanced Macroeconomics 34 / 67 The Ricardian equivalence (cont.) Recall the intertemporal budget constraint (6): cfuture ctoday + = X̄ 1+R The proper interpretation of the lifetime wealth X̄ is the present discounted value of resources net of taxes. According to the Ricardian equivalence, a tax cut today, financed by an increase in taxes in the future, will not affect consumption. In this model, a change in the timing of the taxes will leave X̄ unchanged → the consumer’s maximization problem will be unchanged. Microfoundations ECO3002: Advanced Macroeconomics 35 / 67 Borrowing constraints A key assumption of the neoclassical model is that the agent can freely save and borrow at the market interest rate, R. However, this not true for all consumers: some have no financial wealth and are unable to borrow in the credit markets. Financial conditions could be bad in the economy as a whole, or perhaps the individual’s credit history is not good and no one will provide a a loan. In this case, the constraint on consumption for individuals with no financial wealth and no access to credit is given by: ctoday ≤ ytoday (12) Equation (12) indicates that the agent’s consumption is constrained by the lack of borrowing opportunities to be no greater than her income. Microfoundations ECO3002: Advanced Macroeconomics 36 / 67 Borrowing constraints (cont.) If the agent is already consuming less than her income, then this constraint will be not binding. The consumer is already saving, so not allowing him to borrow does not change anything. However, if the consumer’s income is sufficiently low, she may wish to borrow. In this case, the borrowing constraint binds, and her consumption is constrained to equal her income: ctoday = ytoday When borrowing constraints bind, consumption is exactly equal to income, and the marginal propensity to consume is unity. Microfoundations ECO3002: Advanced Macroeconomics 37 / 67 Precautionary saving When income is uncertain, consumers may save to hedge against the possibility of a large drop in income (associated, for example, with unemployment or disability). Such a consumer might save even when income and wealth are temporarily low, when the basic permanent-income hypothesis would suggest borrowing. This because consumers may engage in precautionary savings to insure themselves from the possibility that income could even fall further. This precautionary-saving motive can lead consumers to behave as if they face borrowing constraints even when they do not. I Consumers with low income save instead of borrowing; I Their consumption may be especially sensitive to their current income (higher marginal propensity to consume). Microfoundations ECO3002: Advanced Macroeconomics 38 / 67 Consumption and credit constraints during financial crises Real per-capita consumption expenditure (2000Q1 = 100). Source: Gerlach-Kristen et al. (2013). Microfoundations ECO3002: Advanced Macroeconomics 39 / 67 Consumption and credit constraints during financial crises (cont.) On the onset of the financial crisis, consumption has dropped markedly in many countries. Why does consumption decline during a crisis? Several explanations for the decline in household spending in the crisis countries. 1 Permanent income has declined, causing a decline in consumption as posited by the permanent income hypothesis. 2 Consumption has fallen because of credit or liquidity constraints: households find access to credit more difficult because of heightened bank-risk aversion, tightened credit standards, or reduced collateral values. 3 Consumption falls due to precautionary savings. In the context of the financial crisis, savings may be used more to deleverage. Microfoundations ECO3002: Advanced Macroeconomics 40 / 67 Consumption and credit constraints during financial crises (cont.) Gerlach-Kristen et al. (2013) examined macroeconomic data in 23 countries over 32 year (1981:Q1-2011:Q4) to assess the impact of financial crises on aggregate consumption. They find that consumption growth is lower during financial crises, particularly during banking crises, and that a drop in income reduces consumption in the short run. This suggests that consumption smoothing is disrupted, and that credit constraints might play a role. They show that in a financial crisis that is accompanied by a property bust, consumption smoothing is most disrupted for mortgage households that are highly leveraged in the housing market. One policy measure to reduce the impact of credit constraints is, thus, to limit the exposure households can take, i.e. to enforce a regulatory maximum loan-to-value ratio (the loan amount by the lender-assessed value of the property). Microfoundations ECO3002: Advanced Macroeconomics 41 / 67 Consumption as a random walk What happens if the agent’s income is uncertain? The neoclassical model implies that consumption today depends on all information the consumer has about the present value of lifetime resources. R. Hall (1978): random walk view of consumption. Assume that this year consumption is denoted by ct and next year consumption is denoted by ct+1. According to the random walk view of consumption, we have that: ct+1 = ct + t+1 (13) Where t+1 is a random error with E (t+1 ) = 0 and Var (t+1 ) = σ2. Microfoundations ECO3002: Advanced Macroeconomics 42 / 67 Consumption as a random walk (cont.) Based on equation (13), because all known information should be incorporated into current consumption, changes in consumption should be unpredictable. Hall reasoned as follows: according to the permanent-income hypothesis, consumers face fluctuating income and try their best to smooth their consumption over time. At any moment, consumers choose consumption based on their current expectations of their lifetime incomes. Over time, they change their consumption because they receive news that causes them to revise their expectations. For example, a person getting an unexpected promotion increases consumption, whereas a person getting an unexpected demotion decreases consumption. Microfoundations ECO3002: Advanced Macroeconomics 43 / 67 Consumption as a random walk (cont.) In other words, changes in consumption reflect surprises about lifetime income. If consumers are optimally using all available information, then they should be surprised only by events that were entirely unpredictable. Therefore, changes in their consumption should be unpredictable as well. Microfoundations ECO3002: Advanced Macroeconomics 44 / 67 The life-cycle model of consumption The life-cycle hypothesis was developed by F. Modigliani in 1957. This model suggests that consumption is based on average lifetime income rather than on income at any given age. Friedman’s permanent income hypothesis complements Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue that consumption should not depend on current income alone. But unlike the life-cycle hypothesis, which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent-income hypothesis emphasizes that people experience random and temporary changes in their incomes from year to year. Microfoundations ECO3002: Advanced Macroeconomics 45 / 67 The life-cycle model of consumption (cont.) Intuition of the life-cycle model of consumption. When people are young and in school, their consumption is typically higher than their income (they may receive money from their parents). As people age and their income rises, their consumption rises more slowly and they save more. When they retire, income falls, but consumption remains relatively stable: people use the saving they accumulated while middle-aged. Microfoundations ECO3002: Advanced Macroeconomics 46 / 67 The life-cycle model of consumption (cont.) Microfoundations ECO3002: Advanced Macroeconomics 47 / 67 The life-cycle model of consumption (cont.) Consider a consumer who expects to live another T years, has wealth of f and expects to earn income y per year until she retires p years from now. What level of consumption will the consumer choose if she wishes to maintain a smooth level of consumption over the course of her life? For simplicity, we assume that the interest rate is zero. The consumer’s lifetime resources are composed by initial wealth, f , and lifetime earnings, p × y. Microfoundations ECO3002: Advanced Macroeconomics 48 / 67 The life-cycle model of consumption (cont.) We assume that consumer wishes to achieve the smoothest possible path of consumption over her lifetime. She can divide up her lifetime resources among her T remaining years of life. Thus:   (f + p × y ) 1 p c= = f + y T T T If every individual in the economy plans consumption like this, then the aggregate consumption function is given by: c = αf + βy (14) Where the parameter α is the marginal propensity to consume out of wealth, and the parameter β is the marginal propensity to consume out of income. Microfoundations ECO3002: Advanced Macroeconomics 49 / 67 Consumption puzzle revisited The life-cycle model of consumer behaviour can solve the consumption puzzle. According to the life-cycle consumption function (14), the average propensity to consume is: c f c = αf + βy ⇒ =α +β y y Because wealth does not vary proportionately with income from person to person or from year to year, we should find that high income corresponds to a low average propensity to consume when we look at data across individuals or over short periods of time. However, over long periods of time, from decades to decades, wealth and income grow together, resulting in a constant ratio yf and thus constant average propensity to consume. Microfoundations ECO3002: Advanced Macroeconomics 50 / 67 Consumption puzzle revisited (cont.) Let’s think at the same point in an alternative way. Consider how the consumption function changes over time. For any given level of wealth, the life-cycle consumption function looks like the one Keynes suggested → but this function holds only in the short-run when wealth is constant. In the long-run, as wealth increases, the consumption function shifts upward → this upwards shift prevents the average propensity to consume from falling as income increases. In this way, Modigliani resolved the consumption puzzle posed by Kuznets. Microfoundations ECO3002: Advanced Macroeconomics 51 / 67 How changes in wealth shift the consumption function If consumption depends on wealth, then an increase in wealth shifts the consumption function upward. Microfoundations ECO3002: Advanced Macroeconomics 52 / 67  Case Study: Household debt since the Global Financial Crisis Microfoundations ECO3002: Advanced Macroeconomics 53 / 67 Household debt Debt allows households to smooth shocks and invest in high-return assets such as housing or education, raising average consumption over their lifetimes. However, high household debt can make the economy more vulnerable to disruptions, potentially harming growth. As aggregate consumption and output shrink, the likelihood of systemic banking distress could increase, since banks hold both direct and indirect credit risk exposures to the household sector. In what follows, we mainly focus on the macroeconomic consequences of household debt. Microfoundations ECO3002: Advanced Macroeconomics 54 / 67 Household debt since GFC (% of GDP) Source: BIS Quarterly Review (2017). Microfoundations ECO3002: Advanced Macroeconomics 55 / 67 Household debt since GFC (% of GDP) (cont.) Countries can be classified into four groups, based on the level and trend of household debt as a ratio to GDP (debt ratio). 1 Countries with debt ratios that are both high (e.g., over 60% of GDP) and trending higher. 2 Countries with high household debt relative to GDP, but the debt ratio trend seems to have either levelled off or declined in recent years. 3 Countries with average household debt ratios below 60% since 2007 and debt ratios have been trending up. 4 Countries with average household debt ratios below 60% since 2007 and debt has fallen. Microfoundations ECO3002: Advanced Macroeconomics 56 / 67 Household debt buffers and burdens (cont.) In order to assess the implications of high household debt, it is crucial to know if households can bear the debt burden without adjusting consumption when circumstances worsen. It is important to establish if households have been accumulating buffers that can help smoothing unexpected adverse changes. I We define leverage the ratio of household debt to financial assets. The size of household debt burdens matters too → this can be measured by the debt service ratio (DSR). I The DSR is the ratio of total required household debt payments to total disposable income. Microfoundations ECO3002: Advanced Macroeconomics 57 / 67 Household debt buffers and burdens (cont.) Source: BIS Quarterly Review (2017). Microfoundations ECO3002: Advanced Macroeconomics 58 / 67 Household debt buffers and burdens (cont.) Household leverage. Leverage is flat for countries in the first and third groups. Households in these countries with rising debt have also seen the value and amount of their assets rise. Households in the second group, where debt is high but falling, seem to have made the most significant progress in repairing balance sheets. In these countries, leverage dropped more than 10% in the 10 years since the GFC. Microfoundations ECO3002: Advanced Macroeconomics 59 / 67 Household debt buffers and burdens (cont.) Notes: Difference of DSRs for the household sector from country-specific long-run aver- ages since 1999. The source is BIS Quarterly Review (2017). Microfoundations ECO3002: Advanced Macroeconomics 60 / 67 Household debt buffers and burdens (cont.) Household debt service ratio. In countries where household debt has been on the rise (groups 1 and 3), DSRs have consistently exceeded their long-term averages in the 10 years since the GFC. However, the DSR dynamics differ across the two groups: while the DSR has been on an upward trend in group 3, its level has been more volatile in group 1. In countries where household debt has been flat or falling (groups 2 and 4), the DSR has been trending down since 2007. Microfoundations ECO3002: Advanced Macroeconomics 61 / 67 Credit demand vs credit supply Why does household debt increase? Rising household debt can reflect either stronger credit demand or an increased supply of credit from lenders, or some combination of the two. Credit demand. Main reasons for its increase. Unconstrained households borrow in order to smooth consumption before an anticipated increase in income or after an unexpected temporary drop in income (e.g., illness, accidents, short-term unemployment). Households borrow to finance investment in illiquid assets with high long-term returns such as housing. Credit demand increases when households are optimistic about income prospects, or because interest rates are low. Microfoundations ECO3002: Advanced Macroeconomics 62 / 67 Credit demand vs credit supply (cont.) Credit supply. Favourable supply conditions can also boost credit to households. In the UK, heightened competition among lenders seems to have resulted in a relaxation of lending standards. Increased competition among banking organizations, has been shown to increase the market share of better performing banks leading to higher efficiency, and lower interest rates. Lending standards: policies that are set in place to create universal guidelines within a financial institution for potential borrowers (i.e., requirements for potential borrowers). Microfoundations ECO3002: Advanced Macroeconomics 63 / 67 Household debt and macroeconomic stability A household’s stock of debt affects its ability to deal with an unanticipated deterioration in its circumstances (e.g., lower income, lower asset prices or higher interest rates). In order to avoid cutting consumption: 1 the household can draw down savings: assets such as stocks or mutual funds can easily be converted into cash → in this case, assets can work as self-insurance; 2 the household can adjust its debt: (i) it can try to reduce its existing debt burden by renegotiating or refinancing; (ii) it can default strategically, if the jurisdictions allows it; (iii) it can obtain additional credit. Microfoundations ECO3002: Advanced Macroeconomics 64 / 67 Household debt and macroeconomic stability (cont.) The attractiveness of the above options and the relative cut in consumption are affected by several features of a household indebtedness: 1 A household with high leverage is less able to adjust by borrowing, as lenders would be less forthcoming → borrowing constraints: households with higher leverage cut spending by more than those with a lower one. Between 2007 and 2009, spending cuts by UK households with debt-to-income ratios above 400% were 10 times higher than those of households with ratios below 100%. 2 If debt is used to finance illiquid wealth, the cut in consumption is higher: for example, large shares of wealth in housing (i.e., mortgage debt). 3 A greater sensitivity of household’s liabilities to the interest rate relative to that of its assets implies that the impact on consumption is larger. 4 High debt can make a household less mobile → less able to find a better job in another place (homeowners are tied down by mortgages). Microfoundations ECO3002: Advanced Macroeconomics 65 / 67 Main references Textbooks. Jones, C., (2024) “Macroeconomics”, Chapters 11 and 16. Mankiw, G., (2022) “Macroeconomics”, Chapter 20. Microfoundations ECO3002: Advanced Macroeconomics 66 / 67 Main references Articles. Bank for International Settlements Quarterly Review (2017) “Household debt: recent developments and challenges” by Anna Zabai. Gerlach-Kristen, P., O’Connell, B., and O’Toole, C., (2013) “How do banking crises affect consumption? Evidence from international crisis episodes”, Economic and Social Research Institute Working Paper 464. Microfoundations ECO3002: Advanced Macroeconomics 67 / 67