The Effect of Liquidity Constraints on Consumption: A Cross-Sectional Analysis in the Context of Bangladesh

Abstract

Permanent Income Hypothesis plays a foundational role in consumption theories as it shifts the analytical focus from current income to long term expected income or permanent income. Although, it introduces a new perspective but it also comes with its own set of challenges. That is the complexity of estimating consumption based on unobservable future income plus the assumption that households face no liquidity constraints. The typical methods in the literature also require specific types of datasets that are mostly not available for a developing country like Bangladesh. To address the challenges of the Permanent Income Hypothesis, the author applies Hayashi’s approach, which introduces liquidity constraints into the model and utilizes cross-sectional dataset, estimated through the Tobit model for empirical testing. Our findings validate the presence of liquidity constrain due to which household fails to follow the consumption pattern per the Permanent Income Hypothesis. The study also confirms the diminishing marginal effects of income and asset on consumption.