Tests for liquidity constraints: a critical survey and some new observations

Abstract

: This chapter surveys recent empirical work on tests for liquidity constraints. The focus of the survey is on the tests based on the Euler equation. Main conclusions are the following. (1) The available evidence indicates that for a significant fraction of households in the population consumption is affected in a way predicted by credit rationing and differential borrowing and lending rates. (2) However, the available evidence does not give answers to such important questions as the response of consumption to permanent and temporary income changes and the validity of the Ricardian equivalence theorem. (3) Future research should examine the cause, not the existence, of liquidity constraints. Introduction The issue of liquidity constraints comes up in several areas of economics. The main ingredient in modern theories of business cycles is the consumer who executes intertemporal optimization through trading in perfectly competitive asset markets. Traditionally, the life cycle-permanent income hypothesis has been the label for such consumer behavior. Some authors have argued that the observed comovements of consumption and income (or the lack thereof) can best be explained by examining the role of liquidity constraints as the additional constraint in the consumers’ decision problem. The notion that consumers are unable to borrow as they desire is also used to argue against the Ricardian doctrine of the equivalence of taxes and deficits. In the literature on implicit labor contracts, the assumption is often made that workers are unable to borrow against future earnings. Liquidity constraints have even been used in some instances as an excuse to focus on static single-period analyses.

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