Academic journal article Economic Inquiry

Liquidity Constraints and Aggregate Consumption Behavior

Academic journal article Economic Inquiry

Liquidity Constraints and Aggregate Consumption Behavior

Article excerpt

LIQUIDITY CONSTRAINTS AND AGGREGATE CONSUMPTION BEHAVIOR

This paper presents time series evidence on the importance of liquidity constraints

in aggregate consumption expenditures. In contrast to previous studies, I find the

proportion of consumption attributable to liquidity constrained behavior to be large

and highly statistically significant. The estimation pays careful attention to the

problems of stochastic consumption and temporal aggregation, and the estimates are shown

to be robust to alternative specifications involving costly adjustment of consumption,

public spending, and to stochastically varying rates of return.

I. INTRODUCTION

In his seminal contribution to econometric testing of the permanent income hypothesis (PIH) under rational expectations, Hall [1978] showed that optimal saving behavior would make consumption close to a random walk. Hall found only minor departures from a random walk and concluded that there is little reason to doubt the hypothesis. Hall's work stimulated a vast and growing field of research on the econometric implications of optimal consumption behavior. (See Hall [1987] for references and a recent survey.) Econometric testing has taken two distinct approaches. The "Euler equation" approach employed by Hansen and Singleton [1982; 1983], and Nelson [1987] follows Hall by testing the unpredictability of changes in aggregate consumption. The second approach, followed by Hall and Mishkin [1982], West [1988], Deaton [1987], and Quah [1990], focuses on innovations in income and examines the sensitivity or volatility of consumption implied by the permanent income hypothesis. Flavin's [1981] work falls between these two approaches. Her formal work tests the restrictions of the "Euler equation" approach, but she interprets the magnitude of the rejections in terms of the sensitivity of consumption implied by the time-series process on income.

The problem with the first approach is that tests of the orthogonality conditions do not yield a meaningful metric with which to assess the size of the departure from the permanent income hypothesis. The results of the second approach are more directly interpretable, but the estimates are sensitive to assumptions on the stochastic structure of labor income and agents' information sets. This paper adopts the Euler equation approach of Hall [1978] but tests the permanent income hypothesis against a tightly parameterized alternative hypothesis. Following Hayashi [1982], I assume a fixed, but unknown, portion of consumption is accounted for by liquidity constrained agents. Estimating the percentage of liquidity constrained consumption provides a statistically powerful and economically meaningful test of the permanent income hypothesis.

The basic model in this paper is quite similar to that in the influential papers by Hayashi [1982] and Flavin [1981]. In contrast to those studies, however, I obtain plausible and highly statistically significant estimates of the percentage of liquidity constrained consumption. The results suggest that from 30 percent to 40 percent of U.S. consumption is accounted for by liquidity constrained consumers. Careful attention is given to the problems of stochastic consumption, temporal aggregation and coefficient instability. Further, the estimates are shown to be robust to alternative specifications involving costly adjustment, Aschauer's [1985] public spending hypothesis, and to stochastically varying rates of return. Flavin's basic point is confirmed -- small departures from the random walk predicted by the permanent income hypothesis could be the result of large structural departures from the permanent income hypothesis.

The paper is organized as follows. Section II presents Hall's model of the permanent income hypothesis under rational expectations and updates his basic results. Section III develops the model of liquidity constraints and the estimation strategy employed in this paper. …

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