Wealth and Volatility

Abstract

Between 2007 and 2013, U.S. households experienced a large and persistent decline in net worth.The objective of this paper is to study the business cycle implications of such a decline.We first develop a tractable monetary model in which households face idiosyncratic unemployment risk that they can partially self-insure using savings.A low level of liquid household wealth opens the door to self-fulfilling fluctuations: if wealth-poor households expect high unemployment, they have a strong precautionary incentive to cut spending, which can make the expectation of high unemployment a reality.Monetary policy, because of the zero lower bound, cannot rule out such expectations-driven recessions.In contrast, when wealth is sufficiently high, an aggressive monetary policy can keep the economy at full employment.Finally, we document that during the U.S. Great Recession wealth-poor households increased saving more sharply than richer households, pointing towards the importance of the precautionary channel over this period.

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