By Rudrani Bhattacharya and Ila Patnaik
How does access to credit impact consumption volatility? Theory and evidence from advanced economies suggests that greater household access to finance smooths consumption. Evidence from emerging markets, where consumption is usually more volatile than income, indicates that financial reform further increases the volatility of consumption relative to output. We address this puzzle in the framework of an emerging economy model in which households face shocks to trend growth rate, and a fraction of them are credit constrained. Unconstrained households can respond to shocks to trend growth by raising current consumption more than rise in current income. Financial reform increases the share of such households, leading to greater relative consumption volatility. Calibration of the model for pre and post financial reform in India provides support for the model’s key predictions.
The relative volatility of consumption to output is higher in less developed economies, which can be rationalized with less developed financial markets. When consumption is more volatile than output, as it is the case for the least developed economies, that becomes more difficult to explain. The issue is slightly different in this paper. As financial markets become more complete, consumption becomes relatively more volatile. The paper explains this in two ways: first the type of shocks is different, as they pertain to the trend growth rate. This has important implication for permanent income volatility. Second there is a composition effect as the number of financially constraint household is reduced, and thus more can borrow against future income and increase consumption. The combination of the two therefore increases the relative volatility of consumption, which eventually should fall back to the numbers we know from the most advanced economies once the composition effect vanishes and trend growth becomes more stable.