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A Theory of the Consumption Function, with and without Liquidity Constraints

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  • Christopher D. Carroll

Abstract

This paper argues that the modern stochastic consumption model, in which impatient consumers face uninsurable labor income risk, matches Milton Friedman's (1957) original description of the Permanent Income Hypothesis much better than the perfect foresight or certainty equivalent models did. The model can explain the high marginal propensity to consume, the high discount rate on future income, and the important role for precautionary behavior that were all part of Friedman's original framework. The paper also explains the relationship of these questions to the Euler equation literature, and argues that the effects of precautionary saving and liquidity constraints are often virtually indistinguishable.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.15.3.23
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Bibliographic Info

Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 15 (2001)
Issue (Month): 3 (Summer)
Pages: 23-45

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Handle: RePEc:aea:jecper:v:15:y:2001:i:3:p:23-45

Note: DOI: 10.1257/jep.15.3.23
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  1. Christopher D. Carroll, 1996. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," NBER Working Papers 5788, National Bureau of Economic Research, Inc.
  2. repec:cup:macdyn:v:5:y:2001:i:2:p:255-71 is not listed on IDEAS
  3. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May.
  4. Bertaut, Carol C. & Haliassos, Michael, 1997. "Precautionary portfolio behavior from a life-cycle perspective," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1511-1542, June.
  5. Campbell, John & Deaton, Angus, 1989. "Why Is Consumption So Smooth?," Scholarly Articles 3221494, Harvard University Department of Economics.
  6. Christopher D. Carroll, 1992. "The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 23(2), pages 61-156.
  7. Todd W. Allen & Christopher D. Carroll, 2001. "Individual Learning About Consumption," NBER Working Papers 8234, National Bureau of Economic Research, Inc.
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