Working Paper: CEPR ID: DP14579
Authors: Tobias Broer
Abstract: How do business cycle fluctuations affect the ability of households to smooth consumption against idiosyncratic shocks? To answer this question, we first document that, in U.S.\ micro-data, individual consumption reacts more to income changes in booms. Standard incomplete markets models, in contrast, where individuals borrow and save to smooth consumption, predict a lower sensitivity of consumption to individual income changes during times of high output. This motivates us to consider an alternative environment where financial frictions are endogenous and arise from lack of contract enforcement, whose business cycle properties have so far not been studied. We show analytically that this model is consistent with a wide variety of cyclical patterns of insurance. In a quantitative application with unemployment risk, we show that the response of individual consumption to job losses differs strongly between times of high and low output, and identify the conditions under which it is procyclical, as in the data.
Keywords: Consumption Smoothing; Risk Sharing; Limited Enforcement; Business Cycles
JEL Codes: E32; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| individual consumption is procyclical (E20) | household consumption reacts more strongly to income changes during economic booms (D12) |
| endogenous financial frictions (E44) | consumption smoothing is more pronounced in bad economic times (E21) |
| cyclical nature of financial frictions (E32) | significantly impact consumption insurance (G52) |
| sensitivity of consumption to income changes is higher in periods of high output (E20) | aligns with empirical observations from CEX data (D12) |