The Effectiveness of Monetary Policy in the Presence of Liquidity Constraints

In recent years the relevance of liquidity and credit constraints in modelling consumers’ expenditure has become an important issue. It was mainly the persistent rejection of the rational expectations permanent income hypothesis by the data that brought the issue to the forefront of the relevant literature. The usual response to the negative results has been to amend the theory to allow for the presence of imperfect capital markets, while at the same time retaining its basic features. But the belated recognition that, in view of the prevalence of liquidity constraints, the implications of the pure theory are empirically untenable, has given rise to the suggestion that the often derided Keynesian consumption function may, after all, be a good approximation to the behaviour of a substantial section of consumers.