We use a rational agent model of savings and labour supply to considering how consumer responses to a worsening of labour market opportunities could be influenced by the extent of private sector indebtedness. Our simulations indicate that responses to a negative labour market shock depend crucially upon the forms of credit rationing to which the population is subject, the expectations of the population, and the time horizon of concern. If the shock is anticipated, or is not recognised, then short-run consumption responses to the regime change projected by our model tend to be small. If, in contrast, the population is surprised by the regime change, and perceives the change to be permanent, then simulated consumption responses in the year following the negative labour market shock are sufficiently large to pose a risk to macro-economic stability. Furthermore, these short-run consumption responses are found to be exaggerated by the imposition of strict credit limits — even where the population is not immediately at risk of experiencing such limits — and dampened when there is a positive relation between the value of debt and the associated interest charge. Consumption responses tend to be amplified when considered over a longer time horizon, although the method of credit rationing is made less important.
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Paper provided by National Institute of Economic and Social Research in its series NIESR Discussion Papers with number
310.