Liquidity constraint

A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.

The existence of liquidity constraint affects the ability of households to transfer resources across time periods, as well as across uncertain states of nature, relative to income.

Many economic models require individuals to save or borrow money from time to time.

A liquidity constraint is an arbitrary limit on the amount an individual can borrow, or an arbitrary alteration in the interest rate they pay. By raising the costs of borrowing, they prevent individuals from fully optimising their behaviour over time.

Actually existing liquidity constraints are mainly due to risk-based behaviour by lenders such as banks.

Mortgage lending is the cheapest way of an individual borrowing money, but is only available to people with enough savings to buy property. Because the loan is secured on a house or other property, it is only accessible to particular individuals (those who have enough savings to put down a deposit). Other forms of credit, like unsecured loans, credit cards and loan sharks, have progressively higher interest rates, and are used more by poorer people.

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