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Rev Fin 2003; 16:597-629
© 2003 the Society for Financial Studies

Dynamic Equilibrium with Liquidity Constraints

Jérôme Detemple
Boston University and CIRANO

Angel Serrat
JPMorgan

Address correspondence to Jérôme Detemple, School of Management, 546E, Boston University, 595 Commonwealth Ave., Boston, MA 02215, or e-mail: detemple{at}bu.edu.

Abstract

This article studies an intertemporal economy with liquidity constrained and unconstrained individuals. We use a stopping time approach to solve the finite horizonconstrained consumption portfolio problem with constant relative risk aversion and to examine the structure of equilibrium. The impact of the constraint on the optimal consumption and the financing portfolio is assessed. The equilibrium state price density is related to the exercise boundary of an American-style contingent claim with nonlinear payoff. This stopping time characterization enables us to prove the existence of an equilibrium and can be implemented numerically. Properties of equilibrium bond and stock returns are examined.


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