A Theory of the Consumption Function, with and Without Liquidity Constraints (Expanded Version)

34 Pages Posted: 20 Jul 2001 Last revised: 25 Sep 2001

See all articles by Christopher D. Carroll

Christopher D. Carroll

Johns Hopkins University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: July 2001

Abstract

This paper argues that the modern stochastic consumption model, in which impatient consumers face uninsurable labor income risk, matches Milton Friedman's (1957) original description of the Permanent Income Hypothesis much better than the perfect foresight or certainty equivalent models did. The model can explain the high marginal propensity to consume, the high discount rate on future income, and the important role for precautionary behavior that were all part of Friedman's original framework. The paper also explains the relationship of these questions to the Euler equation literature, and argues that the effects of precautionary saving and liquidity constraints are often virtually indistinguishable.

Suggested Citation

Carroll, Christopher D., A Theory of the Consumption Function, with and Without Liquidity Constraints (Expanded Version) (July 2001). NBER Working Paper No. w8387, Available at SSRN: https://ssrn.com/abstract=277297

Christopher D. Carroll (Contact Author)

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