A Life-Cycle Model with Unemployment Traps

This paper extends the life-cycle model allowing for a personal disaster risk (PDR) during working age, such as long-term unemployment risk. This non-linear income risk reduces both early consumption and early risk taking, shifting them to later in life, compensating the stimulus due to the longer expected working years of the young. Despite higher wealth, the implied cross-sectional distribution of consumption growth displays negative skewness. Effects are stronger when the rare reduction of labor income is potentially larger, albeit with lower expected value. PDR is a robust, first-order determinant of life-cycle choices, amplifying the welfare losses of suboptimal default investments rules, as well.