Consumption, Disposable Income and Liquidity Constraints

During the last 20 years major changes have occurred in the Portuguese economy. From 1986, when Portugal joined the European Union, until the third stage of Economic and Monetary Union, with the introduction of the Single Currency, profound changes have conditioned the development of the Portuguese economy and the behaviour of economic agents. A new economic regime emerged in Portugal characterized particularly by a strengthening of macroeconomic stability, which was made possible by the effect of price stability and the reduced risk premium in euro area interest rates. The Portuguese participation in the European Union also implied profound reforms in some sectors of the economy, among them the financial sector. The reforms in this sector started in the mid-80’s and culminated with complete liberalization of international capital movements in 1992. These measures implied far reaching changes in the Portuguese banking sector and this paved the way to far greater competitiveness. New financial credit instruments were created and financial intermediation spread was drastically cut. Moreover, the prospects of Portuguese participation in the euro area and the expectation of the reduction in the volatility and in the level of interest rates have also conditioned the behaviour of economic agents, specially the demand for credit. Indeed, in 2005 household indebtedness as a percentage of disposable income in Portugal was 117%, which contrasts with levels of 20% in the beginning of the 90’s. The only country in the euro area to record higher levels of household indebtedness as a percentage of disposable income was Holland in 2004. The literature available on the impact of financial liberalization on economic activity is vast, particularly regarding the impact on consumption and on the relation between consumption and disposable income. Some of the literature uses models based on Life-Cycle/Permanent Income Hypothesis and consider the possibility that some consumers are unable to smooth consumption over the life-cycle, that is, some consumers do not want to or cannot borrow in order to finance their current consumption. In practice, some obstacles may prevent consumers from accessing credit, for example, legal restrictions on bank loans, the need for guarantees or interest rates which are too high. By preventing consumers from borrowing to smooth consumption over the life-cycle, credit constraints could give rise to a high percentage of households taking their consumption decisions, at each point in time, based on their current income rather than on their expected income. This article analyses the sensitivity of consumption to disposable income in Portugal – which will be used as an indicator of liquidity constraints and its evolution over the last years relating it with the economic conditions, among them the major changes carried out in the financial market. The literature in Portugal on this subject is scarce. Luz (1992) presents an estimation for the percentage of consumers with liquidity constraints for the period 1959-1986, using a process of constant coefficients estimate based on the model described in Jappelli and Pagano (1989). Botas (1999) presents a consumption function with agents having liquidity constraints and estimates the evolution of the per