Financial frictions affect how much consumers spend on durable and non-durable goods. Borrowers can face both loan-to-value (LTV) constraints and payment-to-income (PTI) constraints. In this setting, a monetary contraction drastically reduces the amount consumers can borrow to purchase durable goods. We examine these effects in a dynamic stochastic general equilibrium (DSGE) model.

DSGE models with durables predict that when monetary policy tightens, non-durable consumption will fall and durable consumption will rise. But this prediction contradicts empirical evidence, which shows that both types of consumption fall, and durables fall more than non-durables. Studies have tried to resolve this puzzle by integrating LTV constraints into the model, but without much success. In our model, we use a broader set of financial frictions that includes PTI limits on borrowing.

We show that using both LTV and PTI constraints in the model solves the counterfactual increase in durables following a contractionary monetary shock and delivers the correct correlation. Including the PTI limit in the model leads to a decrease in labour supply. This reduces output, which, in turn, makes it more likely that total durable expenditures will fall.