Household Debt and Monetary Policy: Revealing the Cash-Flow Channel

Abstract

We study the effect of monetary policy on spending when households hold debt with variable interest rates. When interest rates on outstanding loans vary with the short-term market interest rate, monetary policy has a direct and immediate effect on households' expenses and disposable income. If households are borrowing constrained, they will respond to a shock to disposable income by adjusting their spending. As a result, a monetary policy-induced interest rate change leads to a larger change in consumption than what is predicted by the elasticity of intertemporal substitution. We examine this cash-flow channel of monetary policy using administrative data on Swedish households. We estimate a strong and statistically significant response in spending to changes in interest expenses. More specifically, we estimate a marginal propensity to consume (including durable consumption) that is around unity or even higher in response to monetary-policy induced changes in interest expenses. For example, highly indebted households with adjustable rate mortgages reduce consumption growth by several percentage points more in response to a one percentage point increase in the household interest rate than households with little debt or fixed rate mortgages. Our findings imply that monetary policy will have a stronger effect on real economic activity when households are highly indebted and have adjustable rate mortgages.

Monetary policy and macroprudential policy: Different and separate?

“… A very open economy with large export and import implies a strong exchange‐rate channel in the transmission mechanism of monetary policy. High household debt with adjustable mortgage rates also implies a strong cash‐flow channel that affects household consumption (Flodén et al, ). …”

The Role of Households’ Borrowing Constraints in the Transmission of Monetary Policy

“…Our work also relates to the literature linking the structure of the mortgage market and the transmission of shocks. Some recent studies have exploited mortgage market heterogeneity to identify shocks at a granular level (e.g., Di Maggio et al (2017); Flodén et al (2017); and Cumming (2018)), while others have taken broader lessons for the role of monetary policy propagation (e.g., Calza et al (2013); Finck et al (2018); and Piskorski and Seru (2018)). In this study we therefore exploit the unique structure and data granularity of this database of the UK mortgage market as a way to understand the channels of interest rate propagation.…”

MoNK: Mortgages in a New-Keynesian Model

“…What distinguishes our debt channel from these studies is that it is the timing of the cash flows over the life of the loan, not just the real present value of the debt position (debt-revaluation/Fisher channel), that matters to households. Various empirical studies (e.g., Kaplan and Violante, 2014;Di Magio et al, 2017;Flodén et al, 2018) suggest cash flow effects are important for middle-class households.…”