Private Sector Debt, Financial Constraints, and the Effects of Monetary Policy: Evidence from the US
| Date | 01 August 2020 |
| Author | Johann Scharler,Max Breitenlechner |
| DOI | http://doi.org/10.1111/obes.12349 |
| Published date | 01 August 2020 |
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©2019 TheAuthors. OxfordBulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
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OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 82, 4 (2020) 0305–9049
doi: 10.1111/obes.12349
Private Sector Debt, Financial Constraints, and the
Effects of Monetary Policy: Evidence from the US
Max Breitenlechner, Johann Scharler
Department of Economics, University of Innsbruck, Universitaetsstrasse 15 A-6020,
Innsbruck, Austria (e-mail: max.breitenlechner@uibk.ac.at, johann.scharler@uibk.ac.at)
Abstract
We characterize the response of U.S. real GDP to monetary policy shocks conditional on
the level of private sector debt and the degree to which financial constraints are binding.
To incorporate state-dependent effects of monetary policy, we use the local projection
framework.We find that although the amount of private sector debt potentiallyweakens the
monetary policy transmission mechanism, policy shocks exert substantially larger effects
on output when high private debt coincides with binding financial constraints.
I. Introduction
Is the economy more sensitive to changes in monetary policy if the private sector is in-
debted? Theoretically, the level of private debt may influence the monetary transmission
mechanism through several channels. The most direct link is the effect of changes in in-
terest rates on the disposable income of households with variable rate loans, and hence,
their spending decisions (Di Maggio et al., 2017; Cloyne, Ferreira and Surico, 2018). A
similar effect is also conceivable for firms through interest expenses and investment deci-
sions (Ippolito, Ozdagli and Perez-Orive, 2018). Firms’ balance sheets and the net worth
of households in the presence of binding credit constraints and collateral requirements rep-
resent another channel through which monetary policy is transmitted to the real economy
(Bernanke and Gertler, 1995). If a monetary expansion, for instance, raises the value of
the collateral, it increases the availability of credit, which in turn influences spending and
investment decisions. Using household level data, Mian and Sufi (2011) demonstrate that
home equity plays a crucial role in this context as it is primarily the spending of home-
owners with mortgage debt that responds to changes in house prices (see also Mian and
Sufi, 2014). Guerrieri and Iacoviello (2017) develop and estimate a DSGE model with
occasionally binding constraints. In their model, shocks to house prices exert larger effects
on consumption when the level of household debt is higher and borrowing constraints are
binding.1Although a higher overall level of private debt implies that these effects should
JEL Classification numbers: C32, E32, E44, E52.
1A related, albeit distinct, branch of the literature studies nonlinearities in the labour market. Petrosky-Nadeauand
Zhang (2017) and Pizzinelli, Theodoridis and Zanetti (2018) show nonlinearities in labour market variablesacross
different phases of the business cycle.
890 Bulletin
become more relevant to the aggregate, resulting in more pronounced effects of policy
shocks, a high debt level could also weaken the transmission mechanism, if it is associated
with exhausted borrowing capacities (Sufi, 2015; Alpanda and Zubairy, 2019).
To explore how the level of debt interacts with the availability of credit, we condition
the effect of policy shocks not only on private sector debt, but also on the extent to which
financial constraints are binding as in R¨uth (2017). Consider, for instance, a monetary
contraction that reduces the value of collateral, and hence, the availabilityof credit. During
financially tranquil periods, households and firms may still have a ready access to loans,
even if the level of existing debt is relatively high. In contrast, if the monetary contraction
occurs at a time when financial constraints are tight, the effect may be more pronounced if
households and firms are highly indebted.
To study these potential nonlinear effects associated with the level of debt and the
availability of credit, we estimate state-dependent responses of U.S. real GDP to mone-
tary policy shocks for the sample 1973Q1 to 2017Q4 using the local projection method
introduced in Jord`a (2005) and apply the Romer and Romer (2004) approach to iden-
tify exogenous monetary policy shocks. Since monetary policy was partially implemented
through unconventional measures during our sample period, we use the shadow short rate
developed in Krippner (2015) instead of the Federal Funds rate targetafter 2008Q4 for the
estimation of monetary policy shocks.2Todistinguish between high and low debt states, we
use the private sector debt-to-GDP ratio relative to its Hodrick–Prescott (HP) trend.3We
proxy financial constraints by the excess bond premium (EBP), introduced byGilchrist and
Zakrajsek (2012), which captures dynamics in bond prices that are purged from expected
losses in the corporate bond market. Gilchrist and Zakrajsek (2012) argue that this residual
component proxies the supply of credit as it represents investors willingness to provide
funds on credit markets.4
Our paper is closely related to Alpanda and Zubairy (2019), who study how private
sector leverage influences the transmission of monetary policy shocks and Harding and
Klein (2018), who analyse the effects of policy shocks during periods of deleveraging. In
this paper, we complement these contributions by explicitly taking into account how the
interaction between private sector debt and financial constraints influences the real effects
of monetary policy shocks.
When we condition the response of output to policyshocks only on the amount of private
sector debt, we find that the response is more pronounced in the low debt state, which is
consistent with Alpanda and Zubairy (2019). However, when we also consider the extent
to which financial constraints are binding, we find that contractionary monetary policy
shocks exert significantly larger effects if high private debt coincides with tight financial
constraints. These results are robust across a broad set of robustness checks including
alternative state definitions, model specifications, and samples.
2Weshow in a robustness analysis that using the shadow rate provided byWu and Xia (2016) gives essentially the
same results.
3Klein (2017), Alpanda and Zubairy (2019) and Bernardini and Peersman (2018) also define debt states in terms
of deviations from the HP trend.
4The EBP is a frequentlyused measure to proxy financial constraints (see e.g. Caldara et al., 2016; G ¨ortz, Tsoukalas
and Zanetti, 2018).
©2019 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and JohnWiley & Sons Ltd.
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