Working Paper: CEPR ID: DP10453
Authors: Jonathan Heathcote; Fabrizio Perri
Abstract: Periods of low household wealth in United States macroeconomic history have also been periods of high business cycle volatility. This paper develops a simple model that can exhibit self-fulfilling fluctuations in the expected path for unemployment. The novel feature is that the scope for sunspot-driven volatility depends on the level of household wealth. When wealth is high, consumer demand is largely insensitive to unemployment expectations and the economy is robust to confidence crises. When wealth is low, a stronger precautionary motive makes demand more sensitive to unemployment expectations, and the economy becomes vulnerable to confidence-driven fluctuations. In this case, there is a potential role for public policies to stabilize demand. Microeconomic evidence is consistent with the key model mechanism: during the Great Recession, consumers with relatively low wealth, ceteris paribus, cut expenditures more sharply.
Keywords: aggregate demand; business cycles; multiple equilibria; precautionary saving
JEL Codes: E12; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low household wealth (D14) | increased susceptibility to confidence shocks (D89) |
| increased susceptibility to confidence shocks (D89) | higher business cycle volatility (E32) |
| high household wealth (G51) | less sensitivity of consumer demand to unemployment expectations (D12) |
| low household wealth (D14) | stronger precautionary saving motive (D15) |
| stronger precautionary saving motive (D15) | increased sensitivity of demand to unemployment expectations (J64) |
| low household wealth (D14) | increased sensitivity of consumption to unemployment risk (D11) |
| public policies aimed at stabilizing demand (E63) | effective during periods of low wealth (E21) |
| low asset values (G32) | deeper recessions tend to be more persistent (E32) |