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Journal of Economic Perspectives: Vol. 15 No. 3 (Summer 2001)

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A Theory of the Consumption Function, with and without Liquidity Constraints

Article Citation

Carroll, Christopher D. 2001. "A Theory of the Consumption Function, with and without Liquidity Constraints." Journal of Economic Perspectives, 15(3): 23-45.

DOI: 10.1257/jep.15.3.23

Abstract

This paper argues that the modern stochastic consumption model, in which impatient consumers face uninsurable labor income risk, matches Milton Friedman's (1957) original description of the Permanent Income Hypothesis much better than the perfect foresight or certainty equivalent models did. The model can explain the high marginal propensity to consume, the high discount rate on future income, and the important role for precautionary behavior that were all part of Friedman's original framework. The paper also explains the relationship of these questions to the Euler equation literature, and argues that the effects of precautionary saving and liquidity constraints are often virtually indistinguishable.

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Authors

Carroll, Christopher D. (Johns Hopkins U)

JEL Classifications

E21: Macroeconomics: Consumption; Saving; Wealth
D91: Intertemporal Consumer Choice; Life Cycle Models and Saving

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