Households with insufficient liquid assets: Consumption responses to income changes

The Liquidity Trap in the Household Balance Sheet

Researchers looked at how different types of families in Europe spend extra money. They found that "poor" families with no savings spend most of a windfall immediately. Meanwhile, "wealthy" families who lack cash but own homes tend to save more of it.

In macroeconomics, understanding how much people spend when their income changes is vital. This helps predict how the broader economy reacts to policy shifts. Traditionally, economists relied on the Life-Cycle and Permanent Income models. These suggest that rational consumers "smooth" their consumption. They use savings to ensure their lifestyle stays steady even when income fluctuates.

However, real-world data often contradicts this. Many people react sharply to even temporary changes in income. The missing piece of the puzzle is the distinction between total wealth and liquid wealth. A household might be "rich" on paper because they own an expensive home. Yet, they are effectively "hand-to-mouth" (HtM) if they lack the cash to pay an unexpected bill.

This study from Ignacio Belloc and José Alberto Molina investigates this gap. It reveals that how a household responds to a windfall depends on their assets. Their reaction changes depending on whether wealth is stuck in a house or sitting in a bank account.

The failure of total wealth as a proxy

Current economic models often struggle because they treat wealth as a single block. If a researcher looks only at total net worth, they might misjudge a homeowner. They might assume a homeowner is financially secure and will not change spending habits if they receive a small bonus.

This approach fails to account for liquidity constraints. These are limits on accessing funds quickly without selling essential assets. The authors argue that relying on aggregate wealth leads to inaccurate predictions. Specifically, it affects the Marginal Propensity to Consume (MPC). The MPC is the fraction of an additional dollar of income that a household spends rather than saves.

If a model assumes everyone has easy access to wealth, it underestimates consumption volatility. It misses those who are "asset-rich but cash-poor." As shown in, the prevalence of these HtM households varies wildly across Europe.

In Greece, the share reaches nearly 71%. This suggests that ignoring liquidity could lead to massive errors in regional economic forecasting.

Stratifying the Hand-to-Mouth mechanism

To solve this, the authors use data from the Household Finance and Consumption Survey (HFCS) from 2010–2023. Instead of a single "poor" category, they divide the HtM population into three groups. This grouping is based on the composition of their balance sheets:

1. Non-HtM: Households with enough liquid assets to buffer income shocks.
2. Poor HtM: Households with almost no assets, neither liquid (cash, stocks) nor illiquid (real estate, pensions).
3. Wealthy HtM: Households with very low liquid wealth but significant illiquid wealth, such as home equity.

The study relies on a "reported preference" approach. Researchers ask households a hypothetical question. They ask: "If you unexpectedly received a windfall equal to one month's income, what percentage would you spend?" This allows the authors to elicit the MPC directly.

To ensure results are not driven by individual personality traits, the authors use a household fixed effects model. This technique controls for "unobserved heterogeneity" (hidden, unchanging personal traits like risk aversion). It filters out these traits to see how HtM status alone drives spending.

Divergent responses to income shocks

The results reveal a striking divergence in how these groups handle extra cash. The authors report that poor HtM households exhibit the highest MPC. These households consume the vast majority of any windfall. This aligns with the theory of binding liquidity constraints. These households use extra money to cover basic consumption that regular income could not reach.

Conversely, the study finds a surprising result for the wealthy HtM group. They display a negative association with the MPC. Even when controlling for unobserved preferences, being a wealthy HtM household correlates with a lower MPC than non-HtM households. In a pooled OLS model, the authors report that wealthy HtM households had an MPC 1.789 percentage points lower than their counterparts.

This suggests that for the wealthy HtM, a small windfall is not enough to change their lifestyle. Instead, they likely use the extra cash for "precautionary savings" (money set aside for future emergencies). They may also use it to pay down debt. This confirms that liquid wealth, not total wealth, drives consumption sensitivity.

Limitations of hypothetical elicitation

The study provides a granular view of European behavior, but it involves trade-offs. The biggest limitation is the reliance on hypothetical scenarios. Because the MPC is measured through "reported preferences" rather than actual transactions, the data may have errors. Respondents might report what they think they should do rather than what they would do.

Additionally, the study does not distinguish the specific purpose of the spending. For wealthy HtM households, the authors cannot tell if the windfall goes toward savings or debt repayment. Finally, the sample includes the period after the COVID-19 pandemic. This timing might have changed how households perceive risk. Such changes could affect how well the findings apply to other times.

The verdict: Prioritize liquidity in policy

The findings are clear. If you want to understand how a population reacts to a stimulus, do not just look at net worth. The authors show that the "wealthy HtM" segment behaves differently from the "poor HtM" segment. This makes them a distinct group for economic modeling.

For policymakers, the verdict is that interventions must be carefully calibrated. A stimulus meant to boost consumption will be highly effective for poor HtM households. However, it will likely be swallowed by savings or debt repayment from wealthy HtM households. The distinction between cash-on-hand and home equity is the most critical variable for success.

Figures from the paper