Optimization of Consumption with Labor Income

Abstract

We present the solution of a portfolio optimization problem for an economic agent endowed with a stochastic insurable stream, under a liquidity constraint over the time interval [0,T]. Generally, the existence of labor income complicates the agent's decisions. Moreover, in the real world the economic agents are restricted in their ability to borrow against their future labor income. We deal with this kind of liquidity constraint following the lines of American option valuation which allows us to give a precise characterization of the optimal consumption as well as the terminal wealth. In a Markovian case, with infinite horizon and HARA utility, we obtain a closed form solution.

JEL Classification: E21, G11