Rural credit markets and consumption smoothing: Evidence from Pakistan

The testable implications of the Permanent Income Hypothesis are derived from the maximization of the present discounted value of expected lifetime utility from consumption. The consumer choice problem is a dynamic decision problem under uncertainty. The first order condition from the optimization is known as the Euler equation. The Euler equation and utility function representing household preferences are used to derive the general form of the econometric model that is used to test the implications of the permanent income hypothesis. The testing procedure requires a decomposition of the households into two groups. The sample is decomposed into likely to be constrained and unconstrained groups, using cluster analysis. The specific form of the econometric model is determined through the specification tests about the nature of the household and the time effects. Finally, the random effect model with household and the time effects is used in the analysis.The Euler equation tests show that most of the households behave according to the Permanent Income Hypothesis. That is, household consumption growth is not affected by the changes in household income for the entire districts of Faisalabad and Dir, and for the unconstrained households of Attock and Badin. The Euler equation is violated for constrained households in Attock and Badin. The negative and significant coefficients of income means that the Permanent Income Hypothesis is rejected due to liquidity constraints.In the districts where households behave according to the Permanent Income Hypothesis, the consumption smoothing mechanisms differ significantly across districts. In Faisalabad, the households are able to smooth consumption through income diversification. The Income from manufacturing, livestock operations, and remittances has been used to makeup the income loss in bad crop years. In Attock, employment in the services sector and livestock sales are used to smooth consumption. The households in Dir use assets as buffer stocks to smooth their consumption.Overall, this research presented very strong evidence that the constrained households are not able to smooth consumption due to liquidity constraints, while other households can smooth consumption using a variety of options. The liquidity constraints are costly in terms of welfare loss to the households.