DP9035 Durable Goods, Borrowing Constraints and Consumption Insurance

Author(s): Enzo Cerletti, Josep Pijoan-Mas
Publication Date: July 2012
Keyword(s): Borrowing Constraints, Consumption Insurance, Durable Goods, Incomplete Markets, Persistence of Income Shocks
JEL(s): D12, D91, E21
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9035

In this paper we study the transmission of income shocks into nondurable consumption in the presence of durable goods. We use a standard a life-cycle model with two goods to characterize the interaction of durability of goods, durability of shocks, and borrowing constraints as determinants of shock transmission. We show that borrowing constraints lead to a substitution between durable and non-durable goods upon arrival of an unexpected income change. This substitution biases the conventional measures of insurance based on the response of non-durable consumption to income changes. The sign of this bias depends critically on the persistence of the shock. We show that households have less insurance against transitory shocks and more insurance against permanent shocks than commonly measured. We calibrate the model economy to the US in order to measure the size of this bias.