Working Paper: NBER ID: w19319
Authors: Chong Wang; Neng Wang; Jinqiang Yang
Abstract: We develop a tractable incomplete-markets model with an earnings process Y subject to permanent shocks and borrowing constraints. Financial frictions cause the marginal (certainty equivalent) value of wealth W to be greater than unity and decrease with liquidity w = W/Y . Additionally, financial frictions cause consumption to decrease with this endogenously determined marginal value of liquidity. Risk aversion and the elasticity of inter-temporal substitution play very different roles on consumption and the dispersion of w. Permanent earnings shocks, especially large discrete stochastic jumps, make consumption smoothing quantitatively difficult to achieve. Borrowing constraints and permanent discrete jump shocks can generate empirically plausible values for marginal propensities to consume in the range of 0.2 to 0.6.
Keywords: Consumption; Savings; Stochastic Income; Recursive Utility
JEL Codes: E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial frictions (G19) | marginal value of liquidity (E41) |
| marginal value of liquidity (E41) | consumption (E21) |
| risk aversion (D81) | consumption (E21) |
| elasticity of intertemporal substitution (D15) | consumption (E21) |
| permanent earnings shocks (E39) | consumption smoothing (D15) |
| borrowing constraints (F34) | marginal propensities to consume (E21) |