How households react to changes in economic circumstances varies considerably. According to new research published in the August 2019 issue of The Economic Journal, not only do affluent households react differently to the same change in circumstances than poorer ones, but the same household is likely to adjust its spending depending on the direction and size of the change.

The study by Dimitris Christelis, Dimitris Georgarakos, Tullio Jappelli, Luigi Pistaferri and Maarten van Rooij uses a Dutch household survey to show how they react. Households were first asked how they would adjust their spending if they experienced a one-off positive shock, such as a welfare payment by the government, and a one-off negative shock, such as a tax increase, both equal to 10% of their monthly income. Four months later they were asked what their response would be if the shocks were equal to 30% of their monthly income.

Asking the same households these four questions allowed comparisons among all possible responses while keeping the other characteristics of the household constant. The authors found that households reduce their spending on non-durable goods in the case of negative income shock considerably more than they increase it when the shock is positive, and this holds whether the shock is small or large.

There is also little difference in the spending response between small and large negative shocks (the spending drop was about 24% of the income drop in both cases), while the response to small positive shocks was larger than to large positive shocks (20% and 14%, respectively). Moreover, the spending drop is larger for households with low levels of liquid assets: households at the top quartile of liquid asset holdings reduce their spending by about 6% less of their income drop compared to households in the bottom quartile.

These findings are consistent with both theoretical and empirical studies that point to the existence of ‘liquidity constraints’ that limit households’ ability to buffer the consequences of a negative income shock with credit cards, bank loans or family transfers. Hence, households need to considerably lower their spending when their income is reduced.

Similarly, when income increases by a small amount the households are more likely to realise their postponed spending and thus spend a larger part of the income increase. When the income increase is larger, however, they are more likely to save a larger part of it to build a buffer that will serve them when times become hard again.

The results have important implications for the design of fiscal stabilisation programmes, as they imply that spending cutbacks and tax increases are likely to significantly affect household welfare by forcing significant reductions in household spending. Equally, large income tax cuts are unlikely to translate into commensurate increases in household spending, while this is more likely for smaller tax cuts.

The findings also suggest that many households feel that they cannot rely on financial firms to help them through hard times. This is an indication of the impairment of credit intermediation during recessions, which is when households need access to credit the most, and this is especially true for households with low levels of financial assets that can only offer real estate as collateral (if they own any). This situation points to the usefulness of policies that preserve as much as possible the flow of credit to less affluent and/or cash-poor households during hard economic times.

Asymmetric Consumption Effects of Transitory Income Shocks by Dimitris Christelis, Dimitris Georgarakos, Tullio Jappelli, Luigi Pistaferri and Maarten van Rooij is published in the August 2019 issue of The Economic Journal.

Dimitris Christelis

Research Fellow at University of Naples

Dimitris Georgarakos

Senior Economist at European Central Bank

Tullio Jappelli

Professor of Economics at University of Naples Federico II

Luigi Pistaferri

Professor of Economics at Stanford University

Maarten van Rooij

Senior Economist at De Nederlandsche Bank