Working Paper: NBER ID: w2369
Authors: Sanford J. Grossman; Guy Laroque
Abstract: We analyze a model of optimal consumption and portfolio selection in which consumption services are generated by holding a durable good. The durable good is illiquid in that a transaction cost must be paid when the good is sold. It is shown that optimal consumption is not a smooth function of wealth; it is optimal for the consumer to wait until a large change in wealth occurs before adjusting his consumption. As a consequence, the consumption based capital asset pricing model fails to hold. Nevertheless, it is shown that the standard, one factor, market portfolio based capital asset pricing model does hold in this environment. It is shown that the optimal durable level is characterized by three numbers (not random variables), say x, y, and z (where x < y < z). The consumer views the ratio of consumption to wealth (c/W) as his state variable. If this ratio is between x and z, then he does not sell the durable. If c/W is less than x or greater than z, then he sells his durable and buys a new durable of size S so that S/W = y. Thus y is his "target" level of c/W. If the stock market moves up enough so that c/W falls below x, then he sells his small durable to buy a larger durable. However, there will be many changes in the value of his wealth for which c/W stays between x and z, and thus consumption does not change. Numerical simulations show that small transactions costs can make consumption changes occur very infrequently. Further, the effect of transactions costs on the demand for risky assets is substantial.
Keywords: Asset Pricing; Portfolio Choice; Durable Goods; Transaction Costs; Consumption
JEL Codes: D91; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal consumption policy characterized by thresholds (D15) | consumer behavior regarding sale of durable goods (D12) |
| transaction costs (D23) | infrequent consumption changes (D12) |
| transaction costs (D23) | lower responsiveness of consumption to changes in wealth (E21) |
| transaction costs (D23) | more risk-averse behavior regarding risky assets (G41) |
| increased transaction costs (D23) | smaller percentage of wealth in risky assets (D14) |
| CCAPM fails to hold (G19) | envelope condition does not apply (L87) |
| transaction costs (D23) | break link between consumption and asset pricing (G19) |
| CCAPM fails to hold (G19) | CAPM holds (G12) |