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Transaction costs and consumption

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  • Li, Geng

Abstract

The rational expectations permanent income hypothesis (RE-PIH) fails to explain several well documented features of consumption behavior. First, the estimated marginal propensity to consume (MPC) for unanticipated transitory income shocks is often much higher than what the theory warrants. Second, the estimated MPC is typically much bigger for small shocks of this type than for large shocks. Third, consumption is often smoothed against large anticipated future income changes but not always against small changes. This paper argues that these findings can be reconciled within a RE-PIH model that includes a cash-in-advance constraint and an assumption that the agent is required to pay a fixed transaction cost to transfer wealth between cash and assets. Key results of the paper include first, the agent follows an s-S rule with respect to cash holdings when he makes wealth-transfer decisions; second, the MPC within the no-transfer band is higher than that out of the band, and can be as high as exactly equal to one; and third, the agent smoothes consumption in response to news of large future income changes but not necessarily to small ones.

Suggested Citation

  • Li, Geng, 2009. "Transaction costs and consumption," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1263-1277, June.
  • Handle: RePEc:eee:dyncon:v:33:y:2009:i:6:p:1263-1277
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    3. Thornton Matheson, 2012. "Security transaction taxes: issues and evidence," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 19(6), pages 884-912, December.
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    5. Dotsey, Michael & Guerron-Quintana, Pablo A., 2016. "Interest rates and prices in an inventory model of money with credit," Journal of Monetary Economics, Elsevier, vol. 83(C), pages 71-89.
    6. Xiaoqing Zhou, 2018. "Home Equity Extraction and the Boom-Bust Cycle in Consumption and Residential Investment," Staff Working Papers 18-6, Bank of Canada.
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    8. Arash Fahim & Wan-Yu Tsai, 2017. "A Numerical Scheme for A Singular control problem: Investment-Consumption Under Proportional Transaction Costs," Papers 1711.01017, arXiv.org.
    9. Christoph Belak & Jörn Sass, 2019. "Finite-horizon optimal investment with transaction costs: construction of the optimal strategies," Finance and Stochastics, Springer, vol. 23(4), pages 861-888, October.
    10. Dai, Min & Wang, Hefei & Yang, Zhou, 2012. "Leverage management in a bull–bear switching market," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1585-1599.
    11. Huiling Wu, 2016. "Optimal Investment-Consumption Strategy under Inflation in a Markovian Regime-Switching Market," Discrete Dynamics in Nature and Society, Hindawi, vol. 2016, pages 1-17, July.
    12. Ms. Thornton Matheson, 2011. "Taxing Financial Transactions: Issues and Evidence," IMF Working Papers 2011/054, International Monetary Fund.
    13. He, Yong & Zhou, Xia & Chen, Peimin & Wang, Xiaoyang, 2022. "An analytical solution for the robust investment-reinsurance strategy with general utilities," The North American Journal of Economics and Finance, Elsevier, vol. 63(C).
    14. Chen, Yingshan & Dai, Min & Xu, Jing & Xu, Mingyu, 2015. "Superhedging under ratio constraint," Journal of Economic Dynamics and Control, Elsevier, vol. 58(C), pages 250-264.
    15. Andreas Lichtenstern & Pavel V. Shevchenko & Rudi Zagst, 2019. "Optimal life-cycle consumption and investment decisions under age-dependent risk preferences," Papers 1908.09976, arXiv.org.
    16. Nabeel Butt, 2019. "On Discrete Probability Approximations for Transaction Cost Problems," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 26(3), pages 365-389, September.
    17. Dylan Possamai & Guillaume Royer, 2014. "General indifference pricing with small transaction costs," Papers 1401.3261, arXiv.org, revised Apr 2015.
    18. Liu, Qiang & Xiang, Yun & Zhao, Yonghong, 2019. "An outperforming investment strategy under fractional Brownian motion," The North American Journal of Economics and Finance, Elsevier, vol. 47(C), pages 505-515.
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    20. Xinfu Chen & Min Dai & Wei Jiang & Cong Qin, 2022. "Asymptotic analysis of long‐term investment with two illiquid and correlated assets," Mathematical Finance, Wiley Blackwell, vol. 32(4), pages 1133-1169, October.

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