In this chapter, as pointed out in Chapter 1, we develop the base model which serves as the main framework for the subsequent chapters. The distinctive feature of the model developed here is that, unlike the rest of the works in this area, it treats the consumptionsaving and portfolio allocation decisions as being jointly determined. Other authors determine these decisions as either being sequential (see, for example, Bourguignon et al., 1992) or assume that savings are exogenously determined, being independent of the rate of interest (see for example, Morisset, 1993). It is by now widely agreed upon that while the separation of the two decisions may be empirically convenient, it is not conceptually defensible (see for example, Pissarides (1978), Buiter (1980)). Pissarides, for example, has argued that the presence of transaction costs in some asset markets implies the interdependence of consumption and asset choices:
If individuals are aware of these costs, they will also be aware of the importance of their portfolio, since it will, in general, be cheaper to finance consumption by running down liquid assets than by selling long-term assets before maturity.