Discussion Paper Details

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Title: Wealth and Volatility

Author(s): Jonathan Heathcote and Fabrizio Perri

Publication Date: March 2015

Keyword(s): aggregate demand, business cycles, multiple equilibria and precautionary saving

Programme Area(s): International Macroeconomics

Abstract: Periods of low household wealth in United States macroeconomic history have also been periods of high business cycle volatility. This paper develops a simple model that can exhibit self-fulfilling fluctuations in the expected path for unemployment. The novel feature is that the scope for sunspot-driven volatility depends on the level of household wealth. When wealth is high, consumer demand is largely insensitive to unemployment expectations and the economy is robust to confidence crises. When wealth is low, a stronger precautionary motive makes demand more sensitive to unemployment expectations, and the economy becomes vulnerable to confidence-driven fluctuations. In this case, there is a potential role for public policies to stabilize demand. Microeconomic evidence is consistent with the key model mechanism: during the Great Recession, consumers with relatively low wealth, ceteris paribus, cut expenditures more sharply.

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Bibliographic Reference

Heathcote, J and Perri, F. 2015. 'Wealth and Volatility'. London, Centre for Economic Policy Research.