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THE IMPACT OF LEARNING ON BUSINESS CYCLE FLUCTUATIONS IN THE CONSUMER UNSECURED CREDIT MARKET

Published online by Cambridge University Press:  23 November 2018

Matthew N. Luzzetti  and
Seth Neumuller
Matthew N. Luzzetti
Affiliation:
Deutsche Bank Securities Inc.
Seth Neumuller*
Affiliation:
Wellesley College
*
Address correspondence to: Seth Neumuller, Department of Economics, PNE, Wellesley College, 106 Central Street, Wellesley, MA 02481, USA; e-mail: seth.neumuller@wellesley.edu. Phone: (781) 283-2669.
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Abstract

We document that the credit spread on consumer unsecured debt exhibits a persistent, hump-shaped response to an increase in the charge-off rate. This stylized fact poses a significant challenge for a standard model of consumer default in which lenders have rational expectations and, therefore, the credit spread continuously adjusts to reflect the true default incentives of each borrower. In an effort to explain this feature of the data, we construct a model of consumer default with countercyclical income risk in which lenders learn about default risk over time by observing the history of repayment decisions, as is the case in practice. In addition to matching credit spread dynamics, allowing lenders to learn about default risk substantially improves the model’s ability to generate realistic business cycle fluctuations in the consumer unsecured credit market and match the cross-sectional distribution of unsecured debt and dispersion of interest rates observed in the data.

Keywords

Consumer Unsecured DebtCredit SpreadLearning
Type
Articles
Information
Macroeconomic Dynamics , Volume 24 , Issue 5 , July 2020 , pp. 1087 - 1123
Copyright
© Cambridge University Press 2018

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Footnotes

We would like to thank the two anonymous referees, Kyle Herkenhoff, Lee Ohanian, Casey Rothschild, Daniel Sichel, Akila Werapana, and participants at the 2015 Inter-American Development Bank Conference on Household Debt and Financial Stability hosted by the Central Bank of Chile, Bowdoin College, Wellesley College, and the 2015 Workshop in Macroeconomics at Liberal Arts Colleges hosted by Union College for helpful comments and suggestions. All remaining errors are our own.

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