Household Expectations and the Credit Cycle

Abstract

The paper investigates the role of expectations in the household credit cycle. First, I provide empirical evidence that survey data on expectations have strong predictive power for the dynamics of household debt. Optimism on future income predicts an increase in credit, in line with the permanent income hypothesis. Second, I show that beliefs depart from rationality at the aggregate level in a way coherent with the hypothesis of natural expectations (Fuster et al. (2010)). Then, I provide a tractable model that accounts for these two pieces of evidence and investigate the implications of non-rational expectations on credit. I study a consumption-savings model in which a representative agent has natural expectations. In this economy, a positive shock to income generates a boom-bust cycle in debt as observed in the data. The consumer fails to forecast long-run income and gets over-indebted; eventually, expectations adjust and debt declines. Overall, the model's predictions match well the positive correlation between debt and income which cannot be captured with rational expectations nor with alternative beliefs’ hypotheses.