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Liquidity Constraints of the Middle Class

Author

Listed:
  • Jeffrey Campbell

    (Federal Reserve Bank of Chicago)

  • Zvi Hercowitz

    (Tel Aviv University)

Abstract
Consumption of households with liquid financial assets responds much more to transitory income shocks than the permanent-income hypothesis predicts. That is, middle class households act as if they face liquidity constraints. This paper addresses this puzzling observation with a model of impatient households that face a large recurring expenditure. In spite of impatience, they save as this expenditure draws near. We call such saving made in preparation for a foreseeable event "term saving". Under precautionary saving, good luck drives wealth accumulation, so a high asset level implies an abundance of liquidity. With term saving, assets indicate an impending need for funds and a shortage of liquidity. The borrowing constraint will bind at the time of the expenditure. This separates planning up to that time from the rest of the household's lifetime and thereby shortens its effective horizon. Intertemporal substitution over such a limited period generates strong consumption responses to temporary income changes. As the expenditure approaches, the effective horizon shortens further as the household accumulates assets. Hence, households with more assets have larger consumption responses. We compare a calibrated version of a model that embodies both term saving and precautionary saving motives with observed consumption responses to the 2001 U.S. tax rebate. The model replicates these observations well and also generates "excess smoothness" of aggregate consumption.

Suggested Citation

  • Jeffrey Campbell & Zvi Hercowitz, 2012. "Liquidity Constraints of the Middle Class," 2012 Meeting Papers 98, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:98
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    References listed on IDEAS

    as
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    Cited by:

    1. Stijn Claessens & M Ayhan Kose, 2018. "Frontiers of macrofinancial linkages," BIS Papers, Bank for International Settlements, number 95.
    2. Davide Melcangi & Vincent Sterk, 2020. "Stock Market Participation, Inequality, and Monetary Policy," Staff Reports 932, Federal Reserve Bank of New York.
    3. Max. A. Mosley & Edmund Cornforth, 2023. "The Macroeconomic Effect of the UK’s 2022 Cost-of-Living Payments," Discussion Papers 2316, Centre for Macroeconomics (CFM).
    4. Greg Kaplan & Giovanni L. Violante, 2014. "A Model of the Consumption Response to Fiscal Stimulus Payments," Econometrica, Econometric Society, vol. 82(4), pages 1199-1239, July.
    5. Claudio Michelacci & Andrea Pozzi & Luigi Paciello, 2018. "The extensive margin of aggregate consumption demand," 2018 Meeting Papers 1008, Society for Economic Dynamics.
    6. Marco Angrisani & Sergio Barrera & Luisa R. Blanco & Salvador Contreras, 2021. "The racial/ethnic gap in financial literacy in the population and by income," Contemporary Economic Policy, Western Economic Association International, vol. 39(3), pages 524-536, July.
    7. Joseph Vavra & David Berger, 2012. "Consumption Dynamics During the Great Recession," 2012 Meeting Papers 109, Society for Economic Dynamics.
    8. Maude Toussaint‐Comeau, 2021. "Liquidity constraints and debts: Implications for the saving behavior of the middle class," Contemporary Economic Policy, Western Economic Association International, vol. 39(3), pages 479-493, July.
    9. Campbell, Jeffrey R. & Hercowitz, Zvi, 2009. "The Financial Labor Supply Accelerator," Foerder Institute for Economic Research Working Papers 275727, Tel-Aviv University > Foerder Institute for Economic Research.
    10. Ni, Yinan & Barth, James R. & Sun, Yanfei, 2022. "On the dynamic capital structure of nations: Theory and empirics," Research in International Business and Finance, Elsevier, vol. 62(C).
    11. Kirkby, J. Lars & Mitra, Sovan & Nguyen, Duy, 2020. "An analysis of dollar cost averaging and market timing investment strategies," European Journal of Operational Research, Elsevier, vol. 286(3), pages 1168-1186.

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    More about this item

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household

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