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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
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Handle: RePEc:red:sed012:98
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  1. 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.
  2. Campbell, Jeffrey R. & Hercowitz, Zvi, 2009. "Welfare implications of the transition to high household debt," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 1-16, January.
  3. Tullio Jappeli & Luigi Pistaferri, 2009. "The Consumption Response to Income Changes," Discussion Papers 08-052, Stanford Institute for Economic Policy Research.
  4. Deaton, A., 1989. "Saving And Liquidity Constraints," Papers 153, Princeton, Woodrow Wilson School - Public and International Affairs.
  5. Claudia R. Sahm & Matthew D. Shapiro & Joel Slemrod, 2010. "Household Response to the 2008 Tax Rebate: Survey Evidence and Aggregate Implications," NBER Chapters, in: Tax Policy and the Economy, Volume 24, pages 69-110 National Bureau of Economic Research, Inc.
  6. Jonathan A. Parker, 2011. "Consumer Spending and the Economic Stimulus Payments of 2008," 2011 Meeting Papers 254, Society for Economic Dynamics.
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  9. Kennickell, Arthur & Lusardi, Annamaria, 2005. "Disentangling the importance of the precautionary saving motive," CFS Working Paper Series 2006/15, Center for Financial Studies (CFS).
  10. Zeldes, Stephen P, 1989. "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, vol. 97(2), pages 305-46, April.
  11. Hall, Robert E & Mishkin, Frederic S, 1982. "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households," Econometrica, Econometric Society, vol. 50(2), pages 461-81, March.
  12. N. Gregory Mankiw, 1999. "The Savers-Spenders Theory of Fiscal Policy," Harvard Institute of Economic Research Working Papers 1888, Harvard - Institute of Economic Research.
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  15. Jonathan A. Parker, 1999. "The Reaction of Household Consumption to Predictable Changes in Social Security Taxes," American Economic Review, American Economic Association, vol. 89(4), pages 959-973, September.
  16. 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.
  17. Costas Meghir & Luigi Pistaferri, 2004. "Income Variance Dynamics and Heterogeneity," Econometrica, Econometric Society, vol. 72(1), pages 1-32, 01.
  18. Matthew D. Shapiro & Joel Slemrod, 2009. "Did the 2008 Tax Rebates Stimulate Spending?," American Economic Review, American Economic Association, vol. 99(2), pages 374-79, May.
  19. 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.
  20. Nicholas S. Souleles, 1999. "The Response of Household Consumption to Income Tax Refunds," American Economic Review, American Economic Association, vol. 89(4), pages 947-958, September.
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