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Consumption Dynamics During the Great Recession

  • Joseph Vavra

    (University of Chicago)

  • David Berger

    (Yale University)

Business cycle models typically abstract from the distinction between durable and non-durable consumption. However, in the 2007 recession, durable expenditures fell by three times as much as GDP while non-durable expenditures fell by slightly less than GDP. We show that simple extensions of business cycle models (both with and without complete markets) that assume frictionless durable adjustment are no more successful at matching the behavior of consumption, as they imply a decline in durable expenditures that is too large and a decline in non-durable expenditures that is too small, relative to the recession. Motivated by micro evidence, we introduce fixed costs of durable adjustment into the incomplete markets model and show that the model is able to match the behavior of consumption in the most recent recession. Fixed costs dampen the volatility of durable expenditures and amplify the volatility of non-durable expenditures, as a large fraction of households hold wealth in illiquid durables. In addition, the model implies non-linear dynamics that are in line with time-series data: durable expenditures respond more strongly to shocks during booms than during recessions. Finally, we provide additional evidence that supports our model: using micro panel data we show that households with a large fraction of wealth in durables are less able to insure against income shocks.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 109.

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Date of creation: 2012
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Handle: RePEc:red:sed012:109
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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