Academic journal article Economic Inquiry

Liquidity Constraints with Endogenous Income

Academic journal article Economic Inquiry

Liquidity Constraints with Endogenous Income

Article excerpt

I. INTRODUCTION

The existence of liquidity constraints remains a significant issue within intertemporal models of household choice. As Hayashi [1985b], Cox and Jappelli [1993], and other studies detail, the notion that consumers may be unable to borrow all they desire to finance current consumption carries important implications pertaining to Ricardian equivalence as well as the dynamic effects of government spending versus tax policies. Liquidity constraints have also been advanced as a primary reason for empirical rejections of the Permanent Income/Life Cycle Hypothesis, as discussed in Zeldes [1989].

Testing for the existence of debt constraints with micro data has generated mixed results.(1) Hall and Mishkin [1982], Mariger [1987], Zeldes [1989], Hayashi [1985a], and Duca and Rosenthal [1994] argue for the significance of liquidity constraints. Jappelli [1990] and Duca and Rosenthal [1994] contend that a nontrivial segment of the population faces credit rationing, based upon information from the Survey of Current Finances. On the other hand, the findings of Altonji and Siow [1987], Runkle [1991], Mariger and Shaw [1993], and Attanasio and Weber [1995] provide little evidence of liquidity constraints.

This article investigates liquidity constraints with endogenous income. It centers around the household's intertemporal model with nonseparable consumption and leisure. Following the methodology of Zeldes [1989] and Runkle [1991], the formulation allows for an individual household at a point in time to either face binding or nonbinding liquidity constraints.

Our model extends this work by considering labor supply within the family's choice set, as recommended by Hayashi [1985a] and Attanasio and Weber [1995]. It includes endogenous wage income in the minimum wealth constraint. These features allow for consideration of work-related decisions within household utility maximization under liquidity constraints. For example, a family may choose increased labor supply to remove themselves from a debt constraint or to enable them to apply for a larger loan. This behavior may take the form of increased overtime, finding a second job, or having the spouse enter the labor market.

The model works toward remedying several difficulties associated with empirical testing for liquidity constraints. Following Alessie, Melenberg, and Weber [1988], we derive from the Euler equations an estimable equation for employed households. The equation holds for both liquidity constrained families as well as households that do not face a binding debt constraint.

This result addresses a well-known problem involved with the standard consumption-based utility formulation, as discussed by Hayashi [1985b] and others, the inability to directly estimate the Euler equation(s) for liquidity constrained households. Consequently, work such as Hayashi [1985a], Zeldes [1989], and Runkle [1991] use an a priori criterion to split the sample into suspected liquidity constrained and non-liquidity constrained groups. Their tests are based upon parameter estimates from the group not considered to be debt constrained.

Given estimated structural parameters from the consumption-leisure model, we can obtain estimates related to the individual Lagrange multipliers pertaining to the minimum wealth constraint. These estimated data series enable us to test directly for the presence of credit constraints within the general population.

Primarily due to the difficulty in estimating the Lagrange multipliers, indirect means have generally been used to test for debt constraints over a sample of households. Hall and Mishkin [1982] base their inferences on the excess sensitivity of consumption forecast errors to income innovations. Mariger and Shaw [1993] raise doubts regarding their findings, showing that such tests of the Permanent Income-Life Cycle hypothesis can be biased toward rejection. Zeldes [1989] and Fissel and Jappelli [1990] criticize the general method, since it assumes a constant proportion of liquidity constrained households. …

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