THE IMPACT OF LEARNING ON BUSINESS CYCLE FLUCTUATIONS IN THE CONSUMER UNSECURED CREDIT MARKET

Matthew N. Luzzetti and Seth Neumuller

Macroeconomic Dynamics, 2020, vol. 24, issue 5, 1087-1123

Abstract: We document that the credit spread on consumer unsecured debt exhibits a persistent, hump-shaped response to an increase in the charge-off rate. This stylized fact poses a significant challenge for a standard model of consumer default in which lenders have rational expectations and, therefore, the credit spread continuously adjusts to reflect the true default incentives of each borrower. In an effort to explain this feature of the data, we construct a model of consumer default with countercyclical income risk in which lenders learn about default risk over time by observing the history of repayment decisions, as is the case in practice. In addition to matching credit spread dynamics, allowing lenders to learn about default risk substantially improves the model’s ability to generate realistic business cycle fluctuations in the consumer unsecured credit market and match the cross-sectional distribution of unsecured debt and dispersion of interest rates observed in the data.

Date: 2020
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