credit channels and consumption

7/28/2019 Credit Channels and Consumption

1/10

1

Islamic Economics andFinance Research Group,Universiti Kebangsaan Malaysia,

Bangi 43600, Selangor, Malaysia

Fax: 603-89215789

http://www.ukm.my/ekonis

E-mail: [email protected]

Working Paper in Islamic Economics and Finance No. 0501

Credit Channels and Consumption

Abdul Ghafar Ismail1

Islamic Economics and Finance Research Group

School of EconomicsUniversiti Kebangsaan Malaysia

Bangi, 43600 Selangor D.E., Malaysia

and

Wahyu Ario Pratomo2

Universitas Sumatera Utara

Medan

Sumatera, Indonesia

Tel: 603-8921 5760

Fax: 603-8921 5789

e-mail: [email protected]

This draft, October 2005

Paper to be presented at the International Conference on A Universal Paradigm of

Socio-Scientific Reasoning, Asian University Bangladesh,

Dhaka, December 17-18, 2005

Abstract

The consumption of household generally depends on the excess sensitivity of current

income, which is called liquidity constraint. As the consumption theory developed,

the transmission of monetary policy on interest rate may affect the external finance

premium, which in return make a change in consumption. This paper examines the

relevant of credit channels on private consumption. Using data from 15 Islamic Banks

in Malaysia during 1994-2004, we find that there is a weak tendency of Malaysian to

correspondence with Islamic Banks in order to increase their consumption. The

Malaysian tends to be liquidity constraint in consuming goods and services.

1 Professor of banking and financial economics, Universiti Kebangsaan Malaysia2 Lecturer of financial economics, Universitas Sumatera Utara


2/10

2

Moreover, consumption is quite sensitive to the movement of real interest rate. An

increase of real interest rate attracts Malaysian to save more

JEL Classification numbers: C33; D91; E21;

Keywords: inter-temporal consumer choice; consumption; transmission channel;monetary policy; panel data

1. Introduction

The prohibition of interest in Islam encourages banks to offer products that are based

on al-bay and profit-sharing basis. The same basis was propagated by al-ghazali.

Here, the consumer credit, which is offered through al-bay contract, allow the

consumers to deal with not only personal or family emergencies and needs, but also to

assist them in acquiring consumption goods.

From here, many economists try to reveal the relationship between

consumption and credit consumption. The macroeconomics literatures show that

monetary policy influences the interest rates and hence, the cost of capital. Later, both

affect the aggregate demand variables such as fixed investment, housing inventories

and consumption for durable goods. In turn, changes in aggregate demand affect the

level of production.

The relationship between consumption and credit consumption as suggested

by De Bond (1999) can be seen from the consumers balance sheets. He suggest that

the consumption credit seems to be held for households since there is lack of access

than other forms of credits. His empirical study focuses on the excess sensitivity of

consumption to current income, which is called liquidity constraint. The higher excess

sensitivity means consumers borrow less. In addition, Japelli and Pagano (1989)

propose that this low level of consumer debt might also be due to either from capital

market imperfection or from a low demand for loans.

But, according to credit channel view, the direct effects of monetary policy on

interest rate can be seen through the changes in the external finance premium (EFP),

i.e., the difference in cost between funds raised externally (by issuing equity or debt)

and funds generated internally (by retained earning). According to the credit view,when open market interest rate tends to increase, then EPF also goes up, vice versa.

On the supply side, credit channel imposed EFP to capture the variation in credit

condition. Any shocks to EFP will shock the demand side, the overall price of funds

that borrowers face. Therefore, liquidity constraint ruins the real consumption

decision regardless of whether there is credit rationing or not. The credit channel

theory resumes that the balance sheet channel may be asymmetric over the business

cycle. There would be more informational friction, which leads to the weaker credit

for households.

Therefore, the objective of this paper is to examine the relevant of credit

channels of monetary policy on private consumption. The model is inspired from DeBondts model (1999), a consumption model incorporates credit channels by


3/10


4/10

4

However, obtaining the direct measure of EFP is quite difficult. Many

researchers try to make a proxy to calculate it. Several consumption studies have

already investigated a borrowing-lending wedge as a proxy for EFP. King (1986)

introduces a model in which information asymmetries between borrowers and lenders

lead to an endogenously determined wedge between borrowing and lending rates. Hefinds a significant impact of EFP on the consumption of British. Whilst, Jappeli and

Pagano (1989) reveal that in Sweden, United States and UK aggregate consumption

displays low sensitivity to current income and consumers liabilities are relatively

high. The opposite appears in Italy, Japan, and Spain. However, they find that excess

sensitivity may no originate from liquidity constraint; it is more from desire to borrow

by the household rather than capital market imperfection. They suggest that there is

no relationship between the estimated excess sensitivity of consumption to current

income and the EFP in Italy, and the United Kingdom. Bacchetta and Gerlach (1997)

find that FEP is also unsuccessful in predicting the consumption changes in France

and United Kingdom.

3. The Model

The model of credit channel and consumption in this paper follows several authors

who write the related topic. Winder and Palm (1989), Campbell and Mankiw (1991),

Sarno and Taylor (1998) and De Bondt (1999) suggest that the consumption life cycle

model formulated below implies that consumption follows a random walk with drift,

given the real interest rate (r) is constant, and the intertemporal elasticity of

substitution () is zero.

111 * += tttt rEcE (1)

where is a constant, ct represents real per capita consumption at time t, rt is the real

interest rate at time t (so rt-1 denotes the real interest rate in period t-1). It represents

consumer can borrow or lend. An increase in the real interest rate in previous time or

period t-1 (rt-1) reduces consumption in previous time or period t-1 relative to current

consumption. How much is transferred to the present depends directly on the

coefficient of intertemporal elasticity of substitution (>0).

The literature shows there are two groups of consumers, as suggested by

Keynesian rule of thumb model of Campbell and Mankiw (1991). One group consists

of consumers with liquidity constraint (). They will have the consumption functionas a constant fraction of current income, whilst the other group (1-) is assumed to

behave according to equation (1).

The extension model of equation (1) by putting the group of consumers with

liquidity constraint is as follows:

tttttt yErEcE ++= 1111 ])[1( (2)

where denotes as the parameter of consumers with a constant fraction of income,

and (1-) denotes as the parameter of consumers with a fraction of permanent income(PI). The coefficient yt is per capita real disposable income. Winder and Palm (1989)


5/10

5

show that the excess sensitivity of consumption to current income (or liquidity

constraint) is related to a finite planning time horizon.

Of the assumption required by LC-PIH, the postulate of perfect credit market

has been almost naturally accused for the empirical failure of the theory. If a

consumer cannot borrow and lend at the same level of interest rate to carry out thisoptimal consumption at some stage his desired consumption will subject to his

disposable income, financial assets and the available supply of external finance.

Using De Bondts model (1999), we assume that there are two groups of

liquidity-constraint consumers. One is assumed to consume a constant fraction of

current income (1) and the other group to consume a constant fraction of current

income and the availability supply of external finance (2). Moreover, shifts in this

availability supply of external finance are assumed to depend on the change in the

EFP one period lagged because it takes some time to obtain the external finance

sources for consumption expenditure after a change in the EFP. In addition, the

impact of the EFP on external finance (credit supply) varies over the business cycle

along with credit market imperfection. Meanwhile, the liquidity-unconstrained group

has the parameter (1-1- 2). This leads to a modified -model with financial

accelerator effect becomes

][][])[1( 1121111211 tttttttttt csEyEyErEcE ++++= (3)

we divide equation (3) with Et-1 then we get

][][])[1( 21121 ttttt csyyrc ++++= (4)

where cst denotes credit supply with

cst = (5)11*21

*1

*0 ++ ttt bcEFPEFP

or equivalently

][][])[1( 11*21

*1

*021121 ++++++= ttttttt bcEFPEFPyyrc (6)

])()1()1( 11*221

*12211210221 ++++++= tttttt bcEFPEFPyrc (7)

then we getttttttt bcEFPEFPyrc +++++= 112111 (8)

where bct denotes the business cycle in period t, = (1-1-2) + 2*

0 ; = (1-1-

2); =1 + 2; 1 = 2*

1 ;*

222 = and the error term, t is orthogonal to all

variables known at time t-1 or earlier.

Based on equation (8), three consumption models are estimated. First, we

estimate the credit channel model with liquidity-constrained consumers, where

consumers use only current income. The second estimated model is a modified -

model without financial accelerator effect, which is the impact of the EFP, does not


6/10

6

vary over the business cycle ( ). The third and last model is the modified-

model with financial accelerator effect with no parameter restrictions.

0*2 =

4. Data and Estimation Method

The dependent variable in this study is consumption per capita (c t). We respectively

measure this variable using consumption divided by population. The explanatory

variables are Islamic inter-bank rate (rt), income per capita (yt), external finance

premium (EFPt), and business cycle (bct). The income per capita uses GDP at

constant price of 1997 divided by population, while credit channel is developed from

all of consumption credit that given by 15 Islamic Banks in Malaysia. In order to find

out the influence of business cycle to credit channel, we use dummy variable for crisis

economy appearance. All of data are obtained from Banks Annual Report from 1994

until 2004 and International Financial Statistics.

Basically, the estimated model is

ttttttt bcEFPEFPyrc +++++= 112111 (9)

where ct is consumption per capita, rt is real interest rate, yt is income per capita, EFPt

is external financial premium, and bct is business cycle. Before, equation (9) can be

estimated, firstly, we try to check the stationary of data by using unit root test.

Granger and Newbold (1974) suggested that in the presence of nonstationary

variables, there might be a spurious regression. A spurious regression has a high R2

and t-statistics that appear to be significant, but the results are without any economic

meaning.

The time series ofc, y, r, andEFP are in fact nonstationary time series, that is

generated by random process and can be written as follow:

ttt ZZ += 1 (10)

where t is the stochastic error term that follows the classical assumptions, which

means, it has zero mean, constant variance and is nonautocorrelated (such an error

term is also known as white noise error term) andZ is the time series. As the data

used in this paper is panel data, so we used Levin, Lin and Chu and Im, Pesaran and

Shim W test to check the level of stationary.

Secondly, we will reveal the estimated regression without business cycle and

including business cycles variable to find out the effect of crisis on the demand of

credit in Malaysias Islamic Banks. The estimated regression will be construct in

ordinary least square, fixed effect and random effect. To choose the appropriate

model, we use Hausman Test.

A central assumption in random effects estimation is the assumption that the

random effects are uncorrelated with the explanatory variables. One common method

for testing this assumption is to employ a Hausman (1978) test to compare the fixedand random effects estimates of coefficients.


7/10


8/10

8

Constant -22.866 122.411* 87.740*

rt-1 10.371 -25.286* -26.883**

yt 0.395* 0.283*** 0.303*

EFPt-1 -7.35E-05 -6.13E-05

EFPt-1*bct 0.002**

R2 0.771 0.803R2(adj) 0.690 0.724

* denotes significant at level 1%

** denotes significant at level 5%

*** denotes significant at level 10%

c. Random Effect Method

Table 4: Credit Channel using Random Effect Method

Variable Model 1 Model 2 Model 2

Constant -22.86 124.160* 99.398*

rt-1 10.371 -27.556* -26.787**

yt 0.395* 0.280** 0.297*

EFPt-1 6.97E-05 -0.0001

EFPt-1*bct 0.001**

R2 0.661 0.746 0.772

R2(adj) 0.656 0.732 0.754

* denotes significant at level 1%

** denotes significant at level 5%*** denotes significant at level 10%

Gujarati (2003) states that Random Effect Model is assumed that the intercept

of an individual unit is a random drawing from a much larger population with a

constant mean value. This implication of this statement is that we use Random Effect

Model when the sample is so large and we select the data randomly to represent our

analysis. As this research uses all of Islamic Banks in Malaysia data, therefore we

prefer to choose Fixed Effect Model as a representative model.

As a matter of fact, to strengthen the result, we analyses the result of estimatedregression using Hausman Test. The results shown in Table 5 reveals that Hausman

test is not significant. The thesis underlying is that the Fixed Effect and Random

Effect estimators do not differ substantially. Implementing Gujarati (2003)

recommendation, we use Fixed Effect Model as the representative model of credit

channel.

Table 5: Result of Hausman Test

Chi-Square Stat Df Prob

Cross Section Random 1.677 4 0.7949


9/10

9

The estimated regression reveals that real interest rate, income and economic

shocks will influence household consumption. In case of Malaysia, in average

household tends to liquidity constraint. When their income increases they would like

to save more and less to consume. There is a less motive to ask consumption credit

from banks. It can be seen by the insignificant of parameter EFP. However, when the

economic shocks occur, household tends to increase credit consumption. The sign isnegative shows that an increase in EFP will reduce the motive of household to

demand credit from banks.

5. Conclusions

This study shows that there is a weak tendency of Malaysian to correspondence with

Islamic Banks in order to increase their consumption. The Malaysian tends to be

liquidity constraint in consuming goods and services. Therefore, for monetary

authorities possibly the most relevant conclusion is that credit channel in Malaysias

Islamic Banks need more propagation mechanism. The insignificant of EFP might

indicate that credit channel has not been popular yet among household in Malaysia.Another implication for monetary policy, consumption is quite sensitive to the

movement of real interest rate. An increase of real interest rate attracts Malaysian to

save more. The estimated result shows an increase of 1% real interest rate will

decrease average per capita consumption about 27 Ringgit. The intertemporal

consumption behavior clearly found among the household.

References

Bacchetta, P. and S. Gerlach, 1997, Consumption and Credit Constraints: Some

International Evidence,Journal of Monetary Economics 40, 207-238.

Bernanke, B.S. and M. Gertler, 1995, Inside the Black Box: the Credit Channel of

Monetary Policy Transmission,Journal of Economic Perspectives 9, 1, 27-48.

Campbell, J.Y and N.G. Mankiw, 1991, The Response of Consumption to Income: A

Crosscountry Investigation,European Economic Review 35, 715-721.

Crane, R. D., 1981, "Islamic Commercial Law in Comtemporary Economics,"

Embassy Handbook (Washington, DC: U.S. Department of State).

De Bondt, 1999, Credit Channels and Consumption in Europe: Empirical Evidence,

BIS Working Paper 69

Duessenbery, James and R. Brumberg 1954, Utility Analysis and the Consumption

Function: An interpretation of cross section data, Post Keynesian Economics.

Gujarati, Damodar N., 2003,Basic Econometrics, Mc Graw Hill, Singapore.

Hausman, J. A.. 1978.. "Specification tests in econometrics.."Econometrica. 46: 1251-1271.

Jappelli, T. and M. Pagano, 1989, Consumption and Capital Market Imperfections:

An International Comparison,American Economic Review 79, 1088-1105.

King, M.A., 1986, Capital Market Imperfections and the Consumption Function,

Scandinavian Journal of Economics 88, 59-80.

Kuznets, Simon, 1946, National Income: A Summary Finding, New York: NBER

Milton Friedman, 1957,A Theory of the Consumption Function, Princeton: Princeton

University Press

Modigliani, F. & Brumberg, R., 1954, Utility analysis and the consumption function:

An interpretation of cross-section data. In: Kurihara, K.K (ed.): Post-

Keynesian Economics. New Brunswick, NJ: Rutgers University Press


10/10

10

Sarno, L. and M.P. Taylor, 1998, Real Interest rates, Liquidity Constraints and

Financial Deregulation: Private Consumption Behavior in the UK, Journal of

Macroeconomics 20, 2, 221-242.

Shea, J., 1995, Myopia, Liquidity Constraints, and Aggregate Consumption: a Simple

Test,Journal of Money, Credit, and Banking 27, 3, 798-805.

Winder, C.C.A. and F.C. Palm, 1989, Intertemporal Consumer Behaviour underStructural Changes in Income,Econometric Reviews 8, 1, 1-87.

credit channels and consumption

Documents