Borrowing Restrictions and Wealth Constraints: Implications for Aggregate Consumption

Abstract

Recent empirical studies have found that consumption is more sensitive to current income than the life-cycle, permanent income hypothesis would predict.The present paper studies a model in which the fraction of consumers exhibiting excess sensitivity is endogenously determined. The presence of income uncertainty and restrictions on borrowing are shown to generate adistribution of consumption across individuals which is consistent with the recent empirical evidence. The aggregate marginal propensity to consume out of transitory income is directly related to the fraction of constrained consumers and exhibits positive serial correlation in the face of serially uncorrelated income shocks.