Household Debt and Monetary Policy: Revealing the Cash-Flow Channel

Abstract

We study the effect of monetary policy on spending when households hold debt with variable interest rates. When interest rates on outstanding loans vary with the short-term market interest rate, monetary policy has a direct and immediate effect on households' expenses and disposable income. If households are borrowing constrained, they will respond to a shock to disposable income by adjusting their spending. As a result, a monetary policy-induced interest rate change leads to a larger change in consumption than what is predicted by the elasticity of intertemporal substitution. We examine this cash-flow channel of monetary policy using administrative data on Swedish households. We estimate a strong and statistically significant response in spending to changes in interest expenses. More specifically, we estimate a marginal propensity to consume (including durable consumption) that is around unity or even higher in response to monetary-policy induced changes in interest expenses. For example, highly indebted households with adjustable rate mortgages reduce consumption growth by several percentage points more in response to a one percentage point increase in the household interest rate than households with little debt or fixed rate mortgages. Our findings imply that monetary policy will have a stronger effect on real economic activity when households are highly indebted and have adjustable rate mortgages.