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Inequality, Portfolio Choice and the Great Recession

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Abstract

What drives sharp declines in aggregate quantities over the Great Recession? I study this question by building a dynamic stochastic overlapping generations economy where households hold both low-return liquid and high-return illiquid assets. In this environment, I consider shocks to aggregate TFP that occur alongside a rise in risk of a further economic downturn. Importantly, a higher probability of an economic disaster is consistent with the recent evidence finding a decline in households’ expected income growth over the Great Recession. I also show that a rise in disaster risk explains the rise in savings rates, seen in the micro data over the Great Recession. When calibrated to reproduce the distribution of wealth as well as the frequency and severity of disasters reported in Barro (2006), a rise in disaster risk, and an empirically consistent fall in TFP, explains around 70 percent of the decline in aggregate consumption and more than 50 percent of the decline in investment over the Great Recession. Comparing my model to an economy without illiquid assets, I find that household variation in the liquidity of wealth plays a key role in amplifying the effect of a rise in disaster risk.

Suggested Citation

  • Heejeong Kim, 2019. "Inequality, Portfolio Choice and the Great Recession," Working Papers 19002, Concordia University, Department of Economics.
  • Handle: RePEc:crd:wpaper:19002
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Inequality, Portfolio Choice and the Great Recession
      by Christian Zimmermann in NEP-DGE blog on 2019-03-25 00:55:30

    More about this item

    Keywords

    Business cycles; incomplete markets; disaster risk; portfolio choice;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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