Cristián Echeverría Uncertainty, Liquidity Constraints and the Option Value of Saving

This paper shows that future expected income uncertainty can have significant effects on saving levels in a simple model with a quadratic utility function in which consumers face potentially binding liquidity constraints. By interpreting saving as the option to consume in the future if income happens to be low and the liquidity constraint binds, I propose a theoretical framework for the existence of a significant role for income uncertainty. The existence of liquidity constraints that might bind in the future implies that the ability to postpone irreversible consumption decisions is valuable because it gives consumers the option to avoid or reduce welfare losses in the event of bad states of income. This option value of saving is larger, the greater the income uncertainty that consumers perceive. The paper also proposes to use variables that reflect the status of the labor market as a proxy for income uncertainty in the empirical estimation of the consumption function. (JEL D1, D8, D9, E2) ∗ I am grateful to George Akerlof, Roger Craine and Mark Rubinstein for helpful intuitions. I thank Kris Mitchener, Mark Rodini and Sally Woodhouse for valuable comments. My greatest debt is to David Romer for his numerous and extremely useful suggestions that helped to shape this paper. The responsibility for all mistakes is mine. ∗∗ Department of Economics, University of California, Berkeley. 549 Evans Hall # 3880, Berkeley, C.A. 94720. [email protected] (510) 642-7924. Fax (510) 524-0398.