This paper explores whether the degree of household indebtedness can affect the effectiveness of monetary policy. We take an interacted panel VAR approach, using a panel of 23 countries, thereby obtaining several interesting findings, such as the responses of consumption and investment to monetary shocks are stronger in high levels of household debt. Furthermore, such responses become larger in a contractionary monetary policy stance rather than in an expansionary one, which suggests that monetary policy shocks have asymmetric effects. We have also found that monetary policy has a relatively larger impact in countries with higher share of adjustable-rate loans. Finally, we have found that when a country is in a high-debt state and in a contractionary policy stance, monetary policy is more powerful in countries with a higher share of adjustable-rate loans. We conjecture that these findings support the presence of a cash-flow channel with respect to the transmission of monetary policy in a high household debt state.

Introduction

We investigate whether household indebtedness affects the effectiveness of monetary policy, using a panel of 23 countries and covering the period from 1984:Q1 to 2015:Q4. To this end, we estimate the asymmetric effect of monetary policy dependent on the direction of policy stance, and the level of household indebtedness, thereby departing from the existing related literature, most of which focuses on the average effect of monetary shocks with opposite signs. In addition, we further examine the cash-flow channel in the transmission of monetary policy shocks, analyzing the cross-country differences in the predominant types of interest rate contracts that apply to household debts. If a country is dominated by fixed-rate mortgages (FRMs), one would expect the cash-flow channel to be relatively muted. However, in economies with mostly adjustable-rate mortgages (ARMs), the cash-flow channel may be more important for the transmission of monetary policy. There are some channels through which higher levels of household debt may amplify the effects of monetary policy shocks on overall economic activity. According to the supposed cash-flow channels, monetary policy can have a direct impact on aggregate household spending via the transfer of income between household borrowers and lenders. For example, a decline in interest rates will reduce lenders interest income, while also reducing interest payments on indebted households, resulting in income transfers between the two groups. It has been widely acknowledged that changes in cash flows may affect consumption, particularly for households that are more financially constrained. This implies that the aggregate effects of this transfer may not be muted if borrowing households are financially constrained.