Rational Habit Modification: the Role of Credit

This paper proposes an asymmetric model within which consumer credit facilitates both consumption smoothing and rational habit modification. The model provides a better description of aggregate time series consumption data than competeting models. In particular, the model can account for the various aggregate consumption anomalies that have led to repeated rejections of Hall's (1978) random walk model of consumption. The model is applied to US data using a GMM approach. The evidence suggests that new credit can predict short-run changes in consumption and has assisted consumers to become more forward-looking since 1975.