Consumption insurance and credit shocks

This paper studies how credit shocks affect the pass-through of idiosyncratic productivity shocks to consumption. Using a heterogeneous-agent incomplete-markets model I simulate two different credit shock dynamics as observed in credit panel data, a permanent and a mean-reverting one, and measure consumption insurance along the entire transition path. I show that consumption insurance against idiosyncratic productivity shocks drops on impact for both kind of credit shocks, while they imply qualitative different consumption insurance paths in the medium run. Importantly, I find that these paths differ by current wealth holdings. Asset-poor households experience the largest decrease in consumption insurance, whereas asset-rich households actually have access to more consumption insurance subsequent to a credit shock. Finally, endogenous labor supply attenuates these dynamics.