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Consumption insurance and credit shocks

Working paper 825
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Published: 16 January 2025

By: Stefan Wöhrmüller

This paper studies how credit shocks affect the pass-through of idiosyncratic productivity shocks to consumption. Using a heterogeneous-agent incomplete-markets model I simulate two different credit shock dynamics as observed in credit panel data, a permanent and a mean-reverting one, and measure consumption insurance along the entire transition path. I show that consumption insurance against idiosyncratic productivity shocks drops on impact for both kind of credit shocks, while they imply qualitative different consumption insurance paths in the medium run. Importantly, I find that these paths differ by current wealth holdings. Asset-poor households experience the largest decrease in consumption insurance, whereas asset-rich households actually have access to more consumption insurance subsequent to a credit shock. Finally, endogenous labor supply attenuates these dynamics.

Keywords: consumption insurance; credit shocks; incomplete markets
JEL codes D31; D52; E21; E44

Working paper no. 825

Research highlights:

    • Households use borrowing and lending to smooth consumption over time, but the Great Financial Crisis (GFC) significantly reduced unsecured borrowing capacity, impacting consumption patterns.
    • The study uses a heterogeneous-agent incomplete-markets model to analyze how permanent and mean-reverting credit shocks affect households’ consumption smoothing.
    • Both types of credit shocks reduce economy-wide consumption insurance in the short run, with poorer households experiencing worsened self-insurance and richer households seeing improvements.
    • Permanent credit shocks lead to a gradual smoothing out of deleveraging, while mean-reverting shocks cause an initial overshoot in consumption insurance.
    • The impact of credit shocks varies across the wealth distribution, with poorer households facing larger decreases in consumption insurance, while wealthier households benefit from increased self-insurance.

825 - Consumption insurance and credit shocks

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