Consumption, Down Payments, and Liquidity Constraints

ONE FREQUENTLY CITED EXPLANATION for the empirical failure of the orthodox life cycle-permanent income hypothesis (LC/PIH) is the presence of binding liquidity constraints. ' Households' inability to borrow and lend at the same interest rate or to borrow the desired quantity can distort household consumption profiles, depressing consumption during periods when constraints bind. Whether or not liquidity constraints bind has important implications for the sensitivity of consumption to fluctuations in income, the neutrality of government debt, and the structure of taxation. Despite the potential importance of liquidity constraints in understanding macroeconomic behavior, there has been comparatively little research into the effect of specific constraints on consumption. One area of consumer behavior where liquidity constraints arguably may be important is in housing decisions and mortgage markets. Households wishing to own a first home must accumulate a down payment in order to qualify for a mortgage loan. Currently, for conventional mortgages in the United States, most lending institutions require between S percent and 20 percent of the purchase price of the home put down in advance of the purchase.2 Without access to private gifts or loans, many