This paper presents a new approach to modelling credit restrictions by considering uncertain access to the asset market. The asset market and the stochastic process governing access are considered fully exogenous and independent of income. The model generates stable debt trajectories for a broader array of interest rate levels than the one corresponding to the agent’s rate of time preference. The agent exhibits excess sensitivity of consumption to current period income, even for low probabilities of constraints. Because this sensitivity is inversely related to the maturity of debt contracts, the availability of long-term debt contracts reduces the income-sensitivity of consumption. A very tractable approximative Euler equation for the model is presented.
Introduction: The permanent income hypothesis of consumption, developed by Friedman (Friedman 1957) is based on the assumption that individuals can optimize with respect to their consumption expenditure subject only to the constraint that the present value of there expenditure cannot exceed there total wealth, defined as the present value of there expected future resources.
Author: Leena Rudanko
Source: Research Discussion Papers, Bank of Finland
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