Debt and the Consumption Response to Household Income Shocks

Abstract

This paper exploits a detailed new dataset with comprehensive panel nancial information on millions of American households to investigate the interaction between household balance sheets, income, and consumption during the Great Recession. In particular, I test whether consumption among households with higher levels of debt is more sensitive to a given change in income. I match households to their employers and use shocks to these employers to derive persistent and unanticipated changes in household income. I nd that highly-indebted households are more sensitive to these income uctuations and that a one standard deviation increase in debt-to-asset ratios increases the elasticity of consumption by approximately 25%. I employ household savings and credit availability data to show that these results are driven largely by borrowing and liquidity constraints. These estimates suggest that the drop in consumption during the 2007-2009 recession was approximately 20% greater than what would have been seen with the household balance sheet positions in 1983.