Ebook Housing Wealth, Credit Conditions and Consumption
There is widespread concern among central banks about the influence of house prices on consumption, and much current debate on how monetary policy should react to asset price fluctuations in the context of liberalised credit markets (see Rajan (2005) and associated papers from the Jackson Hole symposium). Housing markets and their consumption interactions have, in recent years, become a very active research area. Nevertheless there is disagreement about the role of housing wealth in explaining consumption.
Unfortunately, much of the empirical literature, both macro and micro, is marred by poor controls for the common drivers both of house prices and consumption, including income, income growth expectations, interest rates, credit supply conditions, other assets and indicators of income uncertainty (such as the changes in the unemployment rate). For example, the easing of credit supply conditions is usually followed by a house price boom. Failure to control for the direct effect of such easing on consumption can result in over estimates of the effect of housing wealth or collateral on consumption. Our review of the literature in Section 2 illustrates these points; and in Sections 4 and 5, we provide specific evidence through comparisons of well-specified empirical models with those omitting relevant controls.
In this paper we apply an empirical model incorporating more complete controls than are generally employed in the literature. These controls include a measure of consumer credit conditions and its interactions with a variety of economic variables such as proxies for income uncertainty, income growth expectations and interest rates. Furthermore, we include a coherent treatment of income growth expectations, missing from most published research.
The application is to the UK, and to an emerging market country, South Africa. Both countries experienced substantial credit market liberalization and rises in consumption to income ratios. However, in South Africa, due to particular circumstances in the 1980s, this occurred without an asset price boom, thus illuminating the direct role of credit liberalization.
The paper incorporates methodological improvements in the measurement of credit conditions, and also clarifies the multi-faceted effects of credit liberalization on consumption. For the UK, we capture the direct and interaction effects of financial liberalization on consumption by employing a consumer credit conditions index, derived by Fernandez Corugedo and Muellbauer (2006). They model data on ten credit indicators, from which a common credit indicator and a risk indicator are extracted, after controlling for standard economic and demographic variables. For South Africa, we estimate joint debt and consumption equations with an unobservable credit supply indicator entering both consumption and debt equations. This indicator is proxied by a linear spline function and the parameters are estimated, subject to cross equation restrictions, from a joint estimation of the household consumption and debt equations incorporating institutional information on credit market liberalization in South Africa.
Furthermore, we distinguish theoretically and empirically among three types of effect of financial liberalization on consumption, which previous literature does not bring out clearly. Financial liberalization reduces the credit constraints on households engaging in smoothing consumption when they expect significant income growth; it reduces deposits required of first-time buyers of housing; and it increases the availability of collateral-backed loans for households which already possess collateral. The three facets imply both a shift in the average propensity to consume, and important interaction effects, for example with housing wealth, income growth expectations, interest rates and indicators of uncertainty.
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