Consumption and Credit: A Model of Time-Varying Liquidity Constraints

Abstract

This paper studies the optimal consumption behavior of individuals who face borrowing limitations that vary stochastically with their income. This framework is motivated by new empirical evidence that I document in U.S. aggregate data: predictable growth in consumer credit is significantly related to consumption growth, a finding that is inconsistent with existing models of consumer behavior. The time-varying liquidity constraint model considered here correctly predicts two key properties of the U.S. aggregate data: the correlation of consumption growth with predictable credit growth documented in this paper, and the well-known correlation between consumption growth and predictable income growth that has been documented extensively elsewhere.

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