Imperfect capital markets and life-cycle consumption

This paper develops a long-range consumption planning model which, unlike conventional life-cycle theory, admits a disparity between borrowing and lending rates of interest. It is shown that, when capital markets are imperfect, optimal consumption depends not only upon an arithmetic average of the household's intertemporal income distribution, the traditional life-cycle income variable, but also upon current income and higher-order moments of that income distribution. The consumption function is estimated using the 1967–1968 CEDE budget survey of four major Colombian cities. A test is made to determine whether the assumption of perfect capital markets is acceptable for empirical approximation. The results strongly indicate that, for households in middle and lower income classes, the explanatory power of the consumption function can be raised by introducing a more flexible life- time budget constraint. The model is then estimated and used to compute the marginal consumption responses of Colombian households to transitory and permanent income changes.