Leverage, Hand-to-Mouth Households, and Heterogeneity of the Marginal Propensity to Consume: Evidence from South Korea

Abstract

This study examines the link between households’ leverage, their liquid assets such as cash holdings or checking accounts, and the Marginal Propensity to Consume (MPC) out of income changes (the effect of an additional dollar of income on consumption) for South Korean households over 2012–2017. To build on previous studies, we precisely redefine the hand-to-mouth households (defined broadly as those who hold little or no liquid assets), and examine the asymmetric effects of the direction of income changes on MPCs. By using the methodology of Hansen (2000), we estimate the threshold of the liquidity ratio (defined as liquid assets to monthly after-tax income) and find that households with liquid assets less than about 2 months of after-tax income show higher MPCs than others. We also find that the leverage ratio and newly defined hand-to-mouth status show asymmetric effects on MPCs by the direction of income changes. The MPC of households with positive income changes is smaller than that of those with negative ones. Furthermore, hand-to-mouth households with high leverage are much more sensitive to negative income changes than positive ones. This result suggests that in economic circumstances where households are highly in debt and have insufficient liquid assets, consumption is likely to be vulnerable to negative income changes, which could hamper aggregate spending growth.