Income uncertainty, liquidity constraints, and the option value of saving

The dissertation addresses the effect of future income uncertainty on household consumption. The first part shows analytically that future expected income uncertainty can have significant effects on the level of individual's saving 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 there is a negative income shock and the liquidity constraint binds, the model proposes a theoretical framework for the existence of a significant role for income uncertainty. The existence of potential liquidity constraints that might bind in the future implies that the ability to postpone irreversible consumption decisions is valuable in itself because it gives consumers the option to avoid or reduce welfare losses in the event of negative income shocks. This option value of saving is larger the greater the income uncertainty that consumers perceive.; Recent empirical work on the effects of future income uncertainty on consumption has yielded varying conclusions. The second part of the dissertation tests the permanent income hypothesis prediction that consumption does not depend on income uncertainty against the alternative hypothesis that consumption depends negatively on income uncertainty. Using an instrumental variables estimation, cross-section time-series income data from the Panel Study on Income Dynamics and cross-section labor market data from the Current Population Survey is matched with cross-section household consumption data from the Consumer Expenditure Survey. The estimation of reduced form consumption equations produces robust results that support the hypothesis that increases in future expected income uncertainty reduces the level of current consumption. The result is robust across age groups, methods to predict current and future income, and measures of predicted future income uncertainty. Furthermore, the results also show an important negative effect of the predicted duration of unemployment on household consumption, a result that is consistent with the predictions from the model developed in the theory part of this study.