Staff Working Paper No. 543: Interest rates, debt and intertemporal allocation: evidence from notched mortgage contracts in the United Kingdom
Michael Carlos Best, James Cloyne, Ethan Ilzetzki and Henrik Jacobsen Kleven
Using a novel source of quasi-experimental variation in interest rates, we study the response of household debt and intertemporal consumption allocation to interest rates. We also develop a new approach to structurally estimate the Elasticity of Intertemporal Substitution (EIS). In the United Kingdom, the mortgage interest rate schedule features discrete jumps — notches — at thresholds for the loan-to-value (LTV) ratio, creating strong incentives for bunching below those thresholds. We document large and sharp bunching below every notch, which translates into sizable interest elasticities of mortgage debt, between 0.1 and 1.4 across different LTV levels. We develop a dynamic model that links these reduced-form responses to the underlying structural EIS. The EIS is much smaller and less heterogeneous than the reduced-form elasticities, between 0.05-0.25 across LTV levels and household types. We show that our structural approach is robust to a wide range of assumptions on beliefs about the future, uncertainty, risk aversion, discount factors and present bias. Our findings have implications for the numerous calibration studies in economics that rely on larger values of the EIS.