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Consumption and credit: a model of time-varying liquidity constraints

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  • Sydney Ludvigson

Abstract

This paper investigates the role of consumer credit in determining real consumption growth in aggregate, post-war U.S. data. This paper presents evidence that predictable growth in consumer credit is significantly related to consumption growth. The finding is inconsistent with the predictions of (I) the permanent income/life cycle hypothesis, (ii) the "rule of thumb" models where some agents simply consume their current income, and (iii) models of liquidity constraints where individuals face a fixed borrowing limit. I argue that this finding calls for reinterpretation of the excess sensitivity of consumption to current resources and suggests a model of liquidity constraints in which the borrowing limitation is time-varying and dependent on current income. The theoretical framework rationalizes the importance of predictable credit growth in determining consumption growth. The model can also be employed to stimulate the real effects of a one-time deregulation, or "evolution" in household credit markets. This exercise indicates that the (constraint induced) dependence of consumption on current resources may not be permanently eliminated when moderate amounts of additional credit are made available. Furthermore, the expansion generates a short term boom in consumption.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9624.

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Date of creation: 1996
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Handle: RePEc:fip:fednrp:9624

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Keywords: Consumption (Economics) ; Credit ; Liquidity (Economics);

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  1. Angus Deaton, 1989. "Saving and Liquidity Constraints," NBER Working Papers 3196, National Bureau of Economic Research, Inc.
  2. Deaton, A. & Laroque, G., 1989. "On The Behavior Of Commodity Prices," Papers 145, Princeton, Woodrow Wilson School - Public and International Affairs.
  3. Stephen Zeldes, . "Consumption and Liquidity Constraints: An Empirical Investigation," Rodney L. White Center for Financial Research Working Papers 24-85, Wharton School Rodney L. White Center for Financial Research.
  4. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  5. Bernanke, Ben & Gertler, Mark & Gilchrist, Simon, 1996. "The Financial Accelerator and the Flight to Quality," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 1-15, February.
  6. 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.
  7. Jappelli, Tullio & Pagano, Marco, 1988. "Consumption and Capital Market Imperfection: An International Comparison," CEPR Discussion Papers 244, C.E.P.R. Discussion Papers.
  8. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  9. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  10. Mervyn Allister King, 1993. "Debt Deflation: Theory and Evidence," FMG Discussion Papers dp175, Financial Markets Group.
  11. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  12. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, vol. 18(1), pages 83-114, January.
  13. Carroll, Christopher D & Fuhrer, Jeffrey C & Wilcox, David W, 1994. "Does Consumer Sentiment Forecast Household Spending? If So, Why?," American Economic Review, American Economic Association, vol. 84(5), pages 1397-1408, December.
  14. Christopher D. Carroll, 1991. "Buffer stock saving and the permanent income hypothesis," Working Paper Series / Economic Activity Section 114, Board of Governors of the Federal Reserve System (U.S.).
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