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Transaction costs and consumption

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  • Geng Li

Abstract

The Rational Expectations Permanent Income Hypothesis (RE-PIH) fails to explain several features of consumption behavior documented by previous researchers. First, the marginal propensity to consume (MPC) out of unanticipated income shocks tends to decrease as the size of the shocks becomes larger. Second, the MPC out of small income shocks is well above what the RE-PIH predicts. Third, consumption responds to small anticipated income changes, but not to large ones. This paper argues that these findings can be reconciled within a RE-PIH framework that includes a cash-in-advance constraint. In the model, the representative agent is assumed to be fully rational with perfect information and is able to borrow against future income. The agent can hold cash and interest-bearing assets, but has to pay a fixed transaction cost to transfer wealth between cash and assets. I show that the agent follows an s-S rule with respect to cash holdings in making wealth-transfer decisions. The MPC within the no-transfer band is higher than that out of the band. It can be lower than or exactly equal to 1. The model also predicts that agents smooth consumption in response to news of large future income changes but not to small ones. Furthermore the model sheds light on the demand for liquid assets and the equity premium puzzle.

Suggested Citation

  • Geng Li, 2007. "Transaction costs and consumption," Finance and Economics Discussion Series 2007-38, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2007-38
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    References listed on IDEAS

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    Cited by:

    1. Thornton Matheson, 2011. "Taxing Financial Transactions; Issues and Evidence," IMF Working Papers 11/54, International Monetary Fund.
    2. 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.
    3. 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.

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    Keywords

    Consumption (Economics) ; Transaction costs;

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