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Wealth and Volatility

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Author Info

  • Fabrizio Perri

    (University of Minnesota)

  • Jonathan Heathcote

    (Federal Reserve Bank of Minneapolis)

Abstract

We first document a strong negative correlation between the level of household net worth, and aggregate business cycle volatility over the past 50 years in the United States. The early 1960s and the Great Moderation of the 1980s and 1990s were periods of high asset values and low volatility. The 1970s and the Great Recession were periods of low asset values and high volatility. We then develop a model in which the level of wealth determines the magnitude of equilibrium aggregate fluctuations. Fluctuations in the model are demand-driven and associated with fluctuations in confidence. Agents must commit to consumption choices before their individual employment status is realized. In the event of unemployment, consumption must be paid for out of savings or through costly borrowing. Asset prices in the model are endogenous, and reflect the liquidity value of wealth. In this environment, expectations of higher unemployment can become self-fulfilling: higher expected unemployment leads households to reduce spending and increase precautionary saving, and in response to falling demand firms reduce hiring. The labor market in the model is decentralized, and equilibrium wages do not necessarily clear the labor market. High levels of household wealth make the economy more robust, in the sense that demand becomes less sensitive to the expected unemployment rate, while lower levels of wealth make the economy more fragile. The paper offers the following interpretation of the Great Recession: a fall in asset values left the economy vulnerable to a sharp decline in confidence, which sharply reduced demand and employment.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1065.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1065

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  1. Martin Lettau & Sydney C. Ludvigson & Jessica A. Wachter, 2004. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?," NBER Working Papers 10270, National Bureau of Economic Research, Inc.
  2. Andrew Benito, 2004. "Does job insecurity affect household consumption?," Bank of England working papers 220, Bank of England.
  3. Veronica Guerrieri & Guido Lorenzoni, 2007. "Liquidity and Trading Dynamics," NBER Working Papers 13204, National Bureau of Economic Research, Inc.
  4. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
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Cited by:
  1. Eric van Wincoop & Philippe Bacchetta, 2013. "The Great Recession: A Self-Fulfilling Global Panic," 2013 Meeting Papers 413, Society for Economic Dynamics.

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