The Effect of Interest Rate on Household Consumption: Evidence from a Natural Experiment in India

Abstract

This paper estimates the change in consumption caused by a higher real interest rate. We exploit the change in Indian banking legislation which encourages all banks to offer a higher interest rate on deposits to citizens above sixty years. We use detailed monthly consumption data from the Indian National Sample Survey to calculate regression discontinuity estimates, based on age cut-offs. We find that an increase of 50 basis points in the interest rate on deposits leads to an immediate decline of consumption expenditure by 12 percent. A study of disaggregated monthly consumption expenditure reveals that the decline is primarily in non-food, non-essential items. We calculate similar estimates for data prior to the banking legislation and find no significant difference in the monthly consumption expenditure. These results are useful in understanding the permanent income hypothesis within the context of an ageing world population.

Keywords: interest rate, consumption expenditure, permanent income hypothesis, life cycle hypothesis

JEL Classification: E21, E62, H31, D91