Borrowing restrictions and wealth constraints: implications for aggregate consumption

Recent empirical studies have found that consumption is more sensitive to current income than simple versions of the life-cycle, permanent income hypothesis would predict. The present paper studies a model in which the fraction of consumers exhibiting excess sensitivity is endogenously determined. The presence of income uncertainty and restrictions on borrowing are shown to generate a distribution of consumption across individuals which is consistent with the recent empirical evidence. The aggregate fraction of consumers facing a binding borrowing constraint is shown to exhibit positive serial correlation in the face of serially uncorrelated income shocks.