Liquidity Constraints, Heterogeneous Consumers and the Risk Free Rate Puzzle

The interaction of liqu id ity constraints and a precautionary savings motive in an economy with consumer heterogeneity in the form of non-stationary, un insurab le , idiosyncratic earnings pro cesses re solves the risk free rate puzzle. The general equ ilibrium bu er stock saving model generates interest rates that match empirical regularities when idiosyncratic sho cks contain both persistent and transitory components. The equilibrium interest rate is further reduced when another sp eci cation of transitory earn ings sho cks (based on microe conometric evidence) is used . Increased exposure to transitory shocks raises precautionary savings; as a resu lt, the required rate of return to clear the cred it market is further reduced and rep licates observed magnitudes for a wider range of parameter sp ec i cations. (JEL D91, E43,G12)