Consumption and Portfolio Selection with Labor Income: A Continuous Time Approach

Abstract

This paper studies the consumption and portfolio selection problem of an agent who is liquidity constrained and has uninsurable income risk. The paper investigates how the optimal consumption and asset allocation policies deviate from the case where the financial market is perfect, i.e., the case where there are no liquidity constraints and uninsurable income risk. In particular, the paper shows that, for a given level of financial wealth and labor income, optimal consumption is smaller and the optimal level of risk taking is lower in the case where the agent is liquidity constrained and has uninsurable income risk than in the case where the financial market is perfect. The paper also discusses how the agent assesses the value of lifetime labor income and relates this evaluation to optimal consumption and asset allocation policies.