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Borrowing Constraints, the Marginal Propensity to Consume, and the Effectiveness of Fiscal Policy

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  • Thomas Bishop

    ()
    (Sungkyunkwan University)

  • Cheolbeom Park

    ()
    (Korea University)

Abstract

Available evidence suggests that the average marginal propensity to consume (MPC) from the 2001 tax rebate in the US was not nearly as large as that from previous tax cuts. We examine if this phenomenon can be explained by the fact that the widespread use of credit cards has made borrowing accessible for most US households by constructing a model that simulates the dynamic effect of relaxed borrowing constraints. Our model uses Kreps-Porteus preferences which account for independent measures of relative risk aversion and the elasticity of intertemporal substitution, both of which can theoretically affect the willingness to save or spend. Our model shows that the average MPC drops substantially immediately after borrowing constraints are relaxed because few consumers having binding borrowing constraints at that time. The model also shows that consumers gradually reduce their wealth after borrowing constraints are relaxed, causing more of them to have binding constraints over time, which in turn causes the average MPC to rise gradually to a new steady state value that is slightly lower than the original value. This dynamic pattern of the MPC suggests that a greater ability to borrow with credit cards could explain the lower effectiveness of the 2001 tax rebate. In addition, the model predicts that consumers choose to hold lower amounts of liquid assets for precautionary reasons when they have a greater ability to borrow unsecured debt.

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Bibliographic Info

Paper provided by Institute of Economic Research, Korea University in its series Discussion Paper Series with number 1008.

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Date of creation: 2010
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Handle: RePEc:iek:wpaper:1008

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Keywords: marginal propensity to consumer; borrowing constraints; precautionary saving; elasticity of intertemporal subsitution; tax cut;

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References

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  1. Souleles, Nicholas S., 2002. "Consumer response to the Reagan tax cuts," Journal of Public Economics, Elsevier, vol. 85(1), pages 99-120, July.
  2. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  3. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
  4. Sydney Ludvigson, 1999. "Consumption And Credit: A Model Of Time-Varying Liquidity Constraints," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 434-447, August.
  5. David S. Johnson & Jonathan A. Parker & Nicholas S. Souleles, 2004. "Household Expenditure and the Income Tax Rebates of 2001," NBER Working Papers 10784, National Bureau of Economic Research, Inc.
  6. Christopher D. Carroll & Miles S. Kimball, 2001. "Liquidity Constraints and Precautionary Saving," NBER Working Papers 8496, National Bureau of Economic Research, Inc.
  7. Ana M. Aizcorbe & Arthur B. Kennickell & Kevin B. Moore, 2003. "Recent changes in U.S. family finances: evidence from the 1998 and 2001 Survey of Consumer Finances," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-32.
  8. Carroll, Christopher D, 1997. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," The Quarterly Journal of Economics, MIT Press, vol. 112(1), pages 1-55, February.
  9. Matthew D. Shapiro & Joel Slemrod, 1993. "Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding," NBER Working Papers 4344, National Bureau of Economic Research, Inc.
  10. Matthew D. Shapiro & Joel Slemrod, 2003. "Did the 2001 Tax Rebate Stimulate Spending? Evidence from Taxpayer Surveys," NBER Chapters, in: Tax Policy and the Economy, Volume 17, pages 83-110 National Bureau of Economic Research, Inc.
  11. David B. Gross & Nicholas S. Souleles, 2002. "Do Liquidity Constraints And Interest Rates Matter For Consumer Behavior? Evidence From Credit Card Data," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 149-185, February.
  12. Peter S. Yoo, 1998. "Still charging: the growth of credit card debt between 1992 and 1995," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 19-27.
  13. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  14. Jappelli, Tullio, 1990. "Who Is Credit Constrained in the U.S. Economy?," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 219-34, February.
  15. Edward Castronova & Paul Hagstrom, 2004. "The Demand for Credit Cards: Evidence from the Survey of Consumer Finances," Economic Inquiry, Western Economic Association International, vol. 42(2), pages 304-318, April.
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  1. Why recent tax rebates did not work
    by Economic Logician in Economic Logic on 2010-05-18 13:57:00

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