Abstract
Capital market imperfections are widely believed to explain why consumption deviates from the martingale implications of the REPIH. However, empirical modelling and theoretical analysis of consumption under capital market imperfections is hindered by the absence of any tractable theoretical model. By modelling capital market imperfections as consumers facing an upward sloping interest rate schedule (i.e. they can borrow more funds but only at higher rates) we outline just such a model. We derive an analytical Euler equation in observable variables which nests the standard REPIH as well as a model of binding credit constraints. We show via simulation the properties of this Euler equation and its potential at explaining previous rejections of the REPIH. We also consider the wider impact of consumption under capital market imperfections on economic fluctuations. Examining how consumption responds to cyclical and permanent changes in loan supply we conclude that more radical alterations to the REPIH are required if consumption and capital market imperfections are to play a substantive role in accounting for business cycle fluctuations.
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