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