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Debt-backed Household Consumption in Small Countries

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Background to the Research and Motivation: The use of debt to smoothen household consumption has gained more prominence in recent studies, especially with regards to the recent American and European economic and debt crisis since 2008. This is partly because of the considerable rise in household credit financing, both in absolute terms and relative to household income, in many countries over the past two decades; and because the same household credit financing which initially increased household debt and contributed to growth rates during the period prior to the crisis later became debt overhangs for the household and aided the asset market bubbles which later burst (Chmelar, 2013 and Debelle, 2004).

Although household consumption, which is the largest component of the aggregate spending, contributes significantly to the performance of the economy, but the way this consumption is being financed is of more important consequences for macroeconomic stability and the magnitude of the boom-burst movement of the business cycle. Even though a rising household debt may reflect financial market deepening within an economy, economists have argues that such debt trends may also indicate a higher vulnerability for household balance sheets at micro-level, especially in cases where the proportion of household consumption financed by debt is high and consistently outweighs the proportion financed by wages; and such vulnerabilities may raise the possibility of risks of economic slowdown, or even intensify an initial economic slowdown– as it was the case in the period 2008-2009, or at worst case lead to household bankruptcies and investment shutdowns at macro-level (Filardo, 2008).

Economic theory suggests that household consumption spending depends on expectation of changes in future income and debt could be used to smoothen it in the presence of income shocks. However, empirical evidence has shown that the extent to which debt is used to smoothen consumption may vary across economies, depending on the level of borrowing and liquidity constraints, persistence of income shocks, asset prices volatility and other related factors. Empirical studies have further confirmed that, not only has household debt been on the rise, but it also has long-run macro-dynamic implications, and these implications tend to be more severe for economies that have serious domestic and/or international borrowing and liquidity constraints (Baker, 2013; Finocchiaro et. al., 2011; Barba and Pivetti, 2008; Cynamon and Fazzari, 2008; De Resende, 2005).

Despite the plausibility of these previous studies, however, none of them has addressed the central questions of the socially efficient level of debt-backed consumption and to what extent this matter for macroeconomic fluctuations. Although, the causes and magnitude of household debt, in relation to macroeconomic performance, has been discussed extensively in the literature, the proportion of household consumption that is actually financed by debt, which is the central problem of many economies, has not been critically addressed. Also, most of the studies concentrate on the case of developed economies, where problem of liquidity constraint is less severe, while the few that addressed the emerging economy’s case are either limited in scope or suffer methodologically. This research shall address this central question and further compare the analysis for both small-open emerging economy and developed economy.

Research Questions: Against this background, this research shall address the following questions:

  1. Is there a socially efficient level of consumption that should be backed by debt?
  2. How does debt-backed consumption matter for macroeconomic fluctuations?
  3. To what extent should debt-backed consumption be of concern to macroeconomic fluctuations?

Research Objectives: The broad objective of this study is to analyse the dynamism of debt-backed household consumption and how it influences and contributes to macroeconomic fluctuations. Specifically, this thesis intends to:

  1. Determine the socially efficient level of consumption that should backed by debt.
  2. Analyse the linkage between debt-backed consumption and macroeconomic fluctuations.
  3. Ascertain the extent to which debt-backed consumption contributes to macroeconomic fluctuations

Methodology of the Research and Data Analysis: This study shall be approached both theoretically and empirically in order to understand the contemporary realities of debt-backed consumption as well as quantify its macroeconomic implications. The research shall be analysed within a Dynamic Stochastic General Equilibrium (DSGE) modeling framework, adapted to suit the severity of domestic and international liquidity and borrowing constraints for an emerging economy and a developed economy. The model will then be simulated for both types of economies using aggregated household data for each representative economy.

Proposed Research Findings and Dissemination Mechanism: First, The study may find the threshold for debt-backed household consumption in a representative emerging economy to be lower than for a developed economy due to borrowing constraints and weaker financial deepening. Secondly, debt-backed consumption may contribute seriously to macroeconomic fluctuations since it does not only reinforce aggregate household consumption response but also investment response, which is the most volatile component of aggregate demand. Finally, the extent to which debt-backed consumption may matter for macroeconomic fluctuation may differ significantly across these economies. The outcome this research shall be disseminated through seminars, journal articles and workshops.

Contribution to Knowledge: This study shall distinctively contribute to existing knowledge in the area of household financing by examining the nature, structure and proportion of debt-backed consumption, and its implication for macroeconomic fluctuations. It shall also address the issue of whether a socially efficient level of debt-backed household consumption could exist for an economy.


Baker, S.R. (2013). Debt and the consumption response to household income shocks. Retrieved at: http://www.stanford.edu/~srbaker/Papers/Baker_DebtConsumption.pdf

Barba, A., & and Pivetti, M. (2008). Rising household debt: Its causes and macroeconomic implications—a long-period analysis. Cambridge Journal of Economics 2009, 33, 113–137

Chmelar, A. (2013). Household Debt and the European Crisis. A Paper presented at the ECRI Conference on 16 May 2013.

Cynamon, B.Z., & Fazzari, S.M. (2008). Household debt in the consumer age: Source of growth – risk of collapse. Capital and Society, 3(2).

De Resende, C. (2005). Endogenous Borrowing Constraints and Consumption Volatility in a Small Open Economy. Retrieved at: http://web.hec.ca/scse/articles/DeResende.pdf

Debelle, G. (2004). Macroeconomic implications of rising household debt. BIS Working Paper, 153.

Filardo, A. (2008). Household debt, monetary policy and financial stability: Still searching for a unifying model. BIS paper, 46. Retrieved at: https://www.bis.org/repofficepubl/arpresearch_fs_200804.01.pdf

Finocchiaro, D., Nilsson, C., Nyberg, D., & Soultanaeva, A. (2011). Household indebtedness, house prices and the macroeconomy: A review of the literature. Sveriges Riksbank Economic Review 2011, 1.

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