Wealth and Volatility
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 â€œneo-classicalâ€ 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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