Job Risk, Separation Shocks and Household Asset Allocation

This paper investigates how the labor market conditions prior to the Great Recession influenced the magnitude of the consumption decline during the crisis. In particular, it focuses on the interaction between household asset and labor market choices in the face of a lower job separation rate. I build a model that incorporates a jobs ladder, heterogeneity in job risk, saving in liquid and illiquid assets and long term mortgages. The model replicates key features of income process, the positive correlation between job risk and the liquidity of household portfolios and captures the housing choices following a job separation. The joint determination of asset and labor market outcomes provides a novel mechanism by which the state of the economy affects the magnitude of the aggregate response to labor market shocks. The fact the Great Recession occurred following a tranquil labor market environment amplified the negative response of consumption by almost 40 percent. Further, job risk heterogeneity increased the persistence of the consumption decline, while the cross sectional housing response provides evidence in support of the importance of this mechanism during the Great Recession.