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Household Income Risk, Nominal Frictions, and Incomplete Markets

  • Lütticke, Ralph
  • Bayer, Christian
  • Pham, Lien
  • Tjaden, Volker

This paper examines the effects of changes in uncertainty of household income on the macroeconomy. Households face substantial idiosyncratic income risk that is up to two orders of magnitude larger than total factor productivity uncertainty, very persistent and varies substantially over the business cycle. We build a New Keynesian model with heterogeneous agents, where changes in precautionary savings due to time-varying uncertainty depress aggregate activity. With countercyclical markups through sticky prices, increased precautionary savings lower aggregate demand and generate significant output losses as the economy is demand-driven in the short-run. The decline in output is more severe, if the central bank is constrained by the zero lower bound. Our results imply that household income uncertainty may be an important factor in explaining the persistent decline of consumption during the Great Recession.

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File URL: http://econstor.eu/bitstream/10419/79868/1/VfS_2013_pid_532.pdf
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Paper provided by Verein für Socialpolitik / German Economic Association in its series Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order with number 79868.

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Date of creation: 2013
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Handle: RePEc:zbw:vfsc13:79868
Contact details of provider: Web page: http://www.socialpolitik.org/
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  1. Nicholas Bloom & Max Floetotto & Nir Jaimovich & Itay Saporta-Eksten & Stephen Terry, 2013. "Really Uncertain Business Cycles," CEP Discussion Papers dp1195, Centre for Economic Performance, LSE.
  2. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  3. Makoto Nakajima, 2013. "Monetary Policy with Heterogeneous Agents," 2013 Meeting Papers 356, Society for Economic Dynamics.
  4. Storesletten, Kjetil & Telmer, Chris I. & Yaron, Amir, 2001. "The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk," European Economic Review, Elsevier, vol. 45(7), pages 1311-1339.
  5. Susanto Basu & Brent Bundick, 2011. "Uncertainty Shocks in a Model of Effective Demand," Boston College Working Papers in Economics 774, Boston College Department of Economics, revised 20 Sep 2012.
  6. Carroll, Christopher D., 2005. "The method of endogenous gridpoints for solving dynamic stochastic optimization problems," CFS Working Paper Series 2005/18, Center for Financial Studies (CFS).
  7. Toshihiko Mukoyama & Anthony A. Smith & Per Krusell, 2008. "Asset Prices in a Huggett Economy," 2008 Meeting Papers 181, Society for Economic Dynamics.
  8. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October.
  9. Gianluca Violante & Greg Kaplan, 2011. "A Model of the Consumption Response to Fiscal Stimulus Payments," 2011 Meeting Papers 243, Society for Economic Dynamics.
  10. Den Haan, Wouter J., 2010. "Assessing the accuracy of the aggregate law of motion in models with heterogeneous agents," Journal of Economic Dynamics and Control, Elsevier, vol. 34(1), pages 79-99, January.
  11. Bayer, Christian & Juessen, Falko, 2009. "The Life-Cycle and the Business-Cycle of Wage Risk: A Cross-Country Comparison," IZA Discussion Papers 4402, Institute for the Study of Labor (IZA).
  12. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  13. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  14. Khan, Aubhik & Thomas, Julia K., 2003. "Nonconvex factor adjustments in equilibrium business cycle models: do nonlinearities matter?," Journal of Monetary Economics, Elsevier, vol. 50(2), pages 331-360, March.
  15. Hintermaier, Thomas & Koeniger, Winfried, 2010. "The method of endogenous gridpoints with occasionally binding constraints among endogenous variables," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 2074-2088, October.
  16. Rüdiger Bachmann & Christian Bayer, 2011. "Uncertainty Business Cycles - Really?," NBER Working Papers 16862, National Bureau of Economic Research, Inc.
  17. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
  18. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
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