Response of Consumption to Income, Credit and Interest Rate Changes in Australia

Melbourne Institute Working Paper No. 20/05

Date: December 2005


Penelope A. Smith
Lei Lei Song


This paper examines the response of consumption to income, credit and interest rate changes in Australia. In contrast to previous studies on consumption in Australian, this paper adopts an Euler equation approach. The Euler equation derives from the consumers' utility maximising problem under the assumption that rule of thumb consumers have borrowing restrictions. To assess the role of credit explicitly, credit variables are also included in the Euler equation. The paper further assumes that coecients are time-varying. The results conrm the signicant eects of income and credit on consumption and also reveal that while consumption growth is not responsive to interest rate changes, the coecient on the real interest rate was time varying and the coecient becomes smaller in absolute terms since the mid 1990s. This implies that consumption may have been less responsive to interest rate changes since then.

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