Aggregate Fluctuations in a Quantitative Overlapping Generations Economy with Unemployment Risk

We explore business cycles in a quantitative overlapping generations economy where households face both unemployment risk and, conditional on employment, income risk. In this environment, we examine the effect of aggregate shocks on the distribution of consumption, income and wealth across households and how this distribution shapes the aggregate response to these shocks. While TFP fell relatively little, in the recent US recession, there was a large fall in hours worked. Consistency with these observations, in the model, requires a substantial and persistent increase in unemployment risk that disproportionately affects younger working households. Conversely, explaining the reduction in aggregate consumption implies a financial shock to households' net return on assets. This drives a non-monotonic welfare cost of the recession, over generations, varying by the share of income derived from capital and labour. Overall, young workers, and older workers near retirement, suffer the most from the increase in unemployment and the fall in the return on wealth, respectively. Inequality in wealth also shapes the aggregate response of the economy. Aggregate investment falls by more when households face little income risk, holds less precautionary savings, and are more responsive to changes in real interest rates.