Working Paper: CEPR ID: DP10814
Authors: Wouter Den Haan; Pontus Rendahl; Markus Riegler
Abstract: The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features ? in isolation ? dampen them. During recessions, fears of unemployment stir up precautionary sentiments which induces agents to save more. The additional savings may be used as investments in both a productive asset (equity) and an unproductive asset (money). But even a small rise in money demand has important consequences. The desire to hold money puts deflationary pressure on the economy, which, provided that nominal wages are sticky, increases wage costs and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This is a powerful mechanism which causes the model to behave differently from both its complete markets version, and a version with incomplete markets but without aggregate uncertainty. In contrast to previous results in the literature, agents uniformly prefer non-trivial levels of unemployment insurance.
Keywords: business cycles; heterogeneous agents; keynesian; unemployment; magnification; propagation; search friction
JEL Codes: E12; E24; E32; E41; J64; J65
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased unemployment fears (J64) | higher precautionary savings (D14) |
| higher precautionary savings (D14) | higher money demand (E41) |
| higher money demand (E41) | downward pressure on prices (D41) |
| downward pressure on prices (D41) | increased real wage costs (J39) |
| sticky nominal wages (J31) | increased real wage costs (J39) |
| lack of complete insurance against unemployment risk (J65) | exacerbates effects of increased unemployment fears and reduced consumption (E27) |
| Increased unemployment fears (J64) | increased real wage costs (J39) |
| Changes in unemployment benefits (J65) | differing effects on aggregate variables (E19) |
| Increase in unemployment insurance (J65) | improve welfare for all agents during a recession (D69) |