Consumption and Credit Constraints: A Model and Evidence for Ireland

Since the onset of the financial crisis, consumption has fallen in many economies. This paper presents a small-scale DSGE model with occasionally binding credit constraints. Indebted households start facing credit constraints when the value of their main asset, which we assume to be housing, declines. As a response, they stop smoothing consumption and deleverage. We show that even households that only expect to face a credit constraint in the future deleverage. In an Irish dataset collected during the crisis, we reject the permanent income hypothesis for highly leveraged households and thus find evidence for a disruption in consumption smoothing. This effect suggests the presence of credit constraints.