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Consumption and Credit Constraints: A Model and Evidence for Ireland

  • Gerlach, Petra
  • Merola, Rossana

Since the onset of the financial crisis, consumption has fallen 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, which we assume to be housing, declines. As a response, they stop smoothing consumption and deleverage. We show that even households that only expect to face a credit constraint in the future deleverage. In an Irish dataset collected during the crisis, we reject the permanent income hypothesis for highly leveraged households and thus find evidence for a disruption in consumption smoothing. This effect suggests the presence of credit constraints.

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Paper provided by Economic and Social Research Institute (ESRI) in its series Papers with number WP471.

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Date of creation: Nov 2013
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Handle: RePEc:esr:wpaper:wp471
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