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Liquidity Constraints of the Middle Class

  • Jeffrey Campbell

    (Federal Reserve Bank of Chicago)

  • Zvi Hercowitz

    (Tel Aviv University)

Consumption of households with liquid financial assets responds much more to transitory income shocks than the permanent-income hypothesis predicts. That is, middle class households act as if they face liquidity constraints. This paper addresses this puzzling observation with a model of impatient households that face a large recurring expenditure. In spite of impatience, they save as this expenditure draws near. We call such saving made in preparation for a foreseeable event "term saving". Under precautionary saving, good luck drives wealth accumulation, so a high asset level implies an abundance of liquidity. With term saving, assets indicate an impending need for funds and a shortage of liquidity. The borrowing constraint will bind at the time of the expenditure. This separates planning up to that time from the rest of the household's lifetime and thereby shortens its effective horizon. Intertemporal substitution over such a limited period generates strong consumption responses to temporary income changes. As the expenditure approaches, the effective horizon shortens further as the household accumulates assets. Hence, households with more assets have larger consumption responses. We compare a calibrated version of a model that embodies both term saving and precautionary saving motives with observed consumption responses to the 2001 U.S. tax rebate. The model replicates these observations well and also generates "excess smoothness" of aggregate consumption.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 98.

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Date of creation: 2012
Date of revision:
Handle: RePEc:red:sed012:98
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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