Testing for Liquidity Constraints in Euler Equations with Complementary Data Sources

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Abstract
Previous tests for liquidity constraints using consumption Euler equations have frequently split the sample on the basis of wealth, arguing that low-wealth consumers are more likely to be constrained. We propose alternative tests using different and more direct information on borrowing constraints obtained from the 1983 Survey of Consumer Finances. In a first stage we estimate probabilities of being constrained, which are then utilized in a second sample, the Panel Study of Income Dynamics, to estimate switching regression models of the Euler equation. Our estimates indicate stronger excess sensitivity associated with the possibility of liquidity constraints than the sample splitting approach. © 1998 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology

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