Inequality, Disaster risk, and the Great Recession

What drove large declines in aggregate quantities during the Great Recession? I study this question by building a dynamic stochastic overlapping generations economy in which households hold both low-return liquid and high-return illiquid assets. In this economy, I explore how aggregate quantities and the distribution of households respond to a recession driven by an increased risk of a further economic downturn. I find that an increase in disaster risk, and an empirically consistent fall in TFP, explain a significant fraction of the declines in aggregate consumption and investment observed during the Great Recession. Inequality is essential in driving these aggregate results. Comparing my model to an economy without illiquid assets, I show that household differences in both liquid and illiquid assets play a crucial role in amplifying the effects of an increase in disaster risk. (Copyright: Elsevier)