Acknowledgement: We thank Ravi Jagannathan, John Leahy, Jonathan Morduch,

Abstract

This paper estimates the effect of interest rate on household consumption. We exploit a change in Indian banking legislation, which encouraged banks to offer higher interest rate on deposits to citizens above sixty years. We use consumption data from the Indian National Sample Survey to calculate regression discontinuity estimates, based on age cut-offs. We find that a 50 basis point increase in interest rate on deposits leads to an immediate decline of consumption expenditure by 12 percent. This decline is primarily in non-food, non-essential items. Estimates prior to the banking legislation show no significant difference in the consumption expenditure. (JEL E21, E62, H31, D91) The effect of interest rate on consumption is a central concern in macroeconomics. Among many issues that are related to inter-temporal substitution, one of the most relevant from today's perspective is whether consumers can be induced to increase consumption by a reduction in interest rate paid on deposits. In this paper we measure the causal effect of interest rate on consumption. This has crucial implications for understanding the timing and effectiveness of the interest rate as a policy instrument that affects consumption, savings and ultimately the growth rate of an economy

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