Durable Expenditure Dynamics under Time-Varying Income Risk

We explore the relationship between fluctuations in income risk and expenditures on durable goods. First, we study the effect of fluctuations in income risk in a tractable partial equilibrium model of durable expenditure decisions featuring non-convex adjustment costs. Non-convex adjustment costs imply that households follow an Ss-type decision rule. In this setting, temporary increases in income risk raise the option value of postponing purchases. With a mean-preserving income process calibrated to match the US business cycle swings in income risk, the fall in durable expenditures upon entering a recession is three times as large as in the same model without adjustment costs. Second, we investigate the relationship empirically. Using micro level data from the Italian Household Survey of Income and Wealth, we estimate the effect of fluctuations in unemployment risk on durable and non-durable expenditures. We find that durables respond strongly to an increase in unemployment risk, while the effect is negligible and statistically insignificant for non-durable expenditures. We also provide evidence using US time series data.