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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 document a strong negative relation in the United States between wealth and aggregate volatility. For example the 1970s and the late 2000s were periods of low asset values and high volatility. The early 1960s and the Great Moderation of the 1980s and 1990s were periods of high asset values and low volatility. Motivated by this fact, we develop a simple theoretical model that links asset values to the extent of business cycle fluctuations. In our environment economic fluctuations can be driven by fluctuations in household optimism or pessimism (animal spirits), as in traditional Keynesian frameworks. The new element is a precautionary motive in consumption demand, the strength of which varies with aggregate wealth and unemployment risk. This implies that fluctuations due to "animal spirits" (and hence the level of volatility) depend crucially on the value of wealth in the economy. When wealth is high the precautionary motive is weak and demand is not sensitive to change in expectations. In this case the economy has a “neo-classical†unique equilibrium and demand management is not effective as a stabilization policy. When wealth is low the economy is vulnerable to confidence shocks, high volatility is possible due to a multiplicity of equilibria, and there is a role for demand management.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 385.

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Date of creation: 2013
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Handle: RePEc:red:sed013:385

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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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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, 2002. "Does Job Insecurity Affect Household Consumption?," Banco de Espa�a Working Papers 0225, Banco de Espa�a.
  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. Philippe Bacchetta & Eric van Wincoop, 2013. "The Great Recession: A Self-Fulfilling Global Panic," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 13.05, Université de Lausanne, Faculté des HEC, DEEP.

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