Financial Sophistication and Consumer Spending

ABSTRACT Using detailed account‐level data, this paper explores how financial sophistication affects consumers' spending responses to changes in income. I document that, controlling for liquidity, financially unsophisticated consumers display significant spending responses to predictable decreases in their disposable income. Furthermore, they have lower savings rates, fewer liquid savings, and higher debt‐to‐income ratios, leaving them more exposed to income shocks. Robustness tests, supported by anecdotal survey evidence, indicate that these results are driven by some consumers' lack of financial sophistication and their consequent failure to understand their financial contracts, rather than by random idiosyncratic shocks, rational liquidity management, or optimal inattention.