Working Paper: NBER ID: w8496
Authors: Christopher D. Carroll; Miles S. Kimball
Abstract: Economists working with numerical solutions to the optimal consumption/saving problem under uncertainty have long known that there are quantitatively important interactions between liquidity constraints and precautionary saving behavior. This paper provides the analytical basis for those interactions. First, we explain why the introduction of a liquidity constraint increases the precautionary saving motive around levels of wealth where the constraint becomes binding. Second, we provide a rigorous basis for the oft-noted similarity between the effects of introducing uncertainty and introducing constraints, by showing that in both cases the effects spring from the concavity in the consumption function which either uncertainty or constraints can induce. We further show that consumption function concavity, once created, propagates back to consumption functions in prior periods. Finally, our most surprising result is that the introduction of additional constraints beyond the first one, or the introduction of additional risks beyond a first risk, can actually reduce the precautionary saving motive, because the new constraint or risk can hide' the effects of the preexisting constraints or risks.
Keywords: liquidity constraints; precautionary saving; consumption behavior
JEL Codes: C6; D91; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Liquidity Constraint (E41) | Precautionary Saving Motive (E21) |
| Concavity of Consumption Function (D11) | Precautionary Saving Motive (E21) |
| Liquidity Constraint (E41) | Concavity of Consumption Function (D11) |
| Uncertainty (D89) | Concavity of Consumption Function (D11) |
| Concavity of Consumption Function (D11) | Consumption Decisions (D12) |
| Additional Liquidity Constraints (E51) | Precautionary Saving Motive (E21) |