Consumption and credit constraints: a model and evidence from Ireland

After the onset of the financial crisis, consumption fell in many economies. This paper presents a small-scale DSGE model with occasionally binding credit constraints. Indebted households start facing credit constraints when the value of their main asset, housing, declines. As a response, they stop smoothing consumption and start deleveraging. Even households that only expect to face a credit constraint in the future deleverage. Using the Irish Household Budget Survey, we show that most Irish households continued to smooth consumption during the crisis. However, for highly indebted consumption smoothing is disrupted during the crisis. Households with leverage close to but below the standard loan-to-value ratio of 85% also seem to smooth consumption less than normal households. This is rational if they expect a further house price decline and therefore anticipate the need to deleverage in the near future. We interpret these results as evidence of credit constraints that arise from falling property prices.